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Written by Steven Silbiger. Famous book for MBA's...

Written by Steven Silbiger. Famous book for MBA's

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  • 1. ContentsIntroductionDay 1MarketingDay 2EthicsDay 3AccountingDay 4OrganizationalBehaviorDay 5Quantitative AnalysisDay 6FinanceDay 7OperationsDay 8EconomicsDay 9StrategyDay 10MBA Mini-CoursesResearchPublic SpeakingNegotiatingInternational BusinessBusiness LawTen-Day MBA DiplomaAppendix: QuantitativeAnalysis TablesBibliographyMBAAbbreviation LexiconIndexAcknowledgmentsAbout the AuthorPraisefor the Ten-Day MBACopyrightAbout thePublisher
  • 2. IntroductionAfter I earned my MBA, I had a chance toreflect on the two most exhausting andfulfilling years of my life. As I reviewed mycourse notes, I realized that the basics ofan MBA education were quite simple andcould easily be understood by a wideraudience. Thousands of Ten-Day MBAreaders have proven it! Readers areapplying their MBA knowledge every day totheir own business situations. Not onlyuseful in the United States, The Ten-DayMBA has been translated into manylanguages around the world. So manypeople are curious about businesseducation, including doctors, lawyers,businesspeople, and aspiring MBAs. Thisbook answers their questions. The Ten-DayMBA really delivers useful information
  • 3. quickly and easily. Current MBA studentshave written me that they even use thebook to review for exams. Ten-Day MBAsare “walking the walk and talking the talk”of MBAs every business day. It’s proventhat this book can work for you. Written forthe impatient student, The Ten-Day MBAallows readers to really grasp thefundamentals of an MBA without losing twoyears’ wages and incurring an $80,000debt for tuition and expenses.Prospective MBAs can use this book to seeif a two-year investment is worth their while;those about to enter business school canget a big head start on the competition; andthose of you who cannot find the time orthe money can get at least $20,000 of MBAeducation at 99 percent off the list price.Unfortunately, this book cannot provide you
  • 4. with the friendships and lifelong businesscontacts that you can develop at an eliteschool. However, it can impart many of theskills that make MBAs successful.The Ten-Day MBA summarizes theessentials of a Top Ten MBA education.The mystique and the livelihood of the TopTen business schools are predicated onmaking their curriculum appear as uniqueand complex as possible. Companies paythousands of dollars to send theirexecutives to drink from these hallowedfountains of knowledge for a few days. Ispent two years of my life not only drinkingfrom the fountain but also bathing andwashing my clothes in it.Which schools are included in the Top Tenis a subject of considerable debate, asdisplayed by the recent rankings shown at
  • 5. the end of this introduction. The Top Tenactually refers to a group of fifteennationally recognized schools that playmusical chairs for Top Ten ranking. Theydistinguish themselves by long applicationforms, active alumni networks, long lists ofrecruiters, and the ability of their graduatesto demand and receive outrageous startingsalaries. The Top Ten schools require ofcandidates at least two years’ workexperience before admission. Experiencedstudents can enrich class discussions andstudy groups. A great deal of my learningcame from my classmates’ workexperiences.The Top Ten schools do not necessarilyoffer the best teaching, facilities, orcurriculum. Reputation plays a great part intheir status. A variety of rating books are
  • 6. available that give the “inside” story onthose reputations. According to the 1998Business Week poll, “racking up thehighest satisfaction scores from graduatesare, in descending order, UCLA,Pennsylvania, Michigan, Cornell andCarnegie Mellon.” The recruiters’ rankings,on the other hand, are Pennsylvania,Northwestern, Chicago, Columbia, andMichigan.My aim is to cut to the heart of the top MBAprograms’ subject matter clearly andconcisely—the way only an MBA can, andthe way academics would not dare. Tocover the major concepts, I use examplesand outlines and summarize whereverpossible. I slice through the long-windedand self-serving academic readings that attimes I had to trudge through. This book
  • 7. contains only the pearls of wisdom buriedin my thirty-two binders of cases, coursematerials, and notes.I have no vested interest in promoting anyof the business theories presented in thebook. Therefore, this book does not repeatthe same idea over the course of twohundred pages as many popular businessbooks have a tendency to do. I crystallizethe most important concepts in briefpassages so you can learn and rememberthem without losing interest.From my interviews with graduates fromWharton, Harvard, Northwestern, and othertop schools, I learned that all of theirprograms serve up the same MBA meal.Only the spices and presentations of thebusiness banquets vary.
  • 8. The basics of MBA knowledge fall into ninedisciplines. Some schools have carefullycrafted their own exalted names for eachsubject, but their unglorified names are:MarketingEthicsAccountingOrganizational BehaviorQuantitative AnalysisFinanceOperationsEconomicsStrategyThe synthesis of knowledge from all ofthese disciplines is what makes the MBA
  • 9. valuable. In the case of a new productmanager with an MBA, she can not onlysee her business challenges from amarketing perspective, but she canrecognize and deal with the financial andmanufacturing demands created by hernew product. This coordinated,multidisciplinary approach is usuallymissing in undergraduate businesscurricula. By learning about all the MBAdisciplines at once, in one book, you havethe opportunity to synthesize MBAknowledge the way you would at the bestschools.When MBAs congregate, we tend toengage in “MBA babble.” Our use ofmystical abbreviations like NPV, SPC, andMBO is only a ruse to justify our loftysalaries and quick promotions. Please do
  • 10. not be intimidated. MBA jargon is easy tolearn! As you read this book, you too willbegin to think and talk like an MBA.My goal is to make you familiar with thesignificant MBA tools and theories currentlybeing taught at the leading businessschools and to help you understand anddevelop the MBA mind-set. When youfinish the ten days, please feel free to fill inyour name on the diploma at the end of thebook. It serves as evidence of yourscholarship and you should proudly displayit for all your friends to see.Current MBA School RankingsBelow are the most current rankings ofMBA programs. Although the rankingschange from year to year, the sameschools are consistently listed. Schoolnames listed in parentheses immortalize
  • 11. founders and major benefactors. Two-Year MBA Degree ProgramsU.S. News & World Report, March 1998:1. Harvard1. Stanford3. Columbia3. MIT (Sloan)3. Pennsylvania (Wharton)6. Chicago6. Northwestern (Kellogg)8. Dartmouth (Tuck)8. UCLA (Anderson)10. Virginia (Darden)10. Berkeley (Haas)
  • 12. 10. Michigan10. Duke (Fuqua)(Several ties in rankings)Business Week, October 1998:1. Pennsylvania (Wharton)2. Northwestern (Kellogg)3. Chicago4. Michigan5. Harvard6. Columbia7. Duke (Fuqua)8. Cornell9. Stanford10. Dartmouth (Tuck)11. Virginia (Darden)
  • 13. 12. UCLA (Anderson)13. NYU (Stern)14. Carnegie Mellon15. MIT (Sloan)The Insider’s Guide to the Top TenBusiness Schools:ChicagoColumbiaDartmouth (Tuck)HarvardMIT (Sloan)MichiganNorthwestern (Kellogg)Pennsylvania (Wharton)Stanford
  • 14. Virginia (Darden)This book by Tom Fischgrund (1993)provides excellent in-depth profiles of eachschool, written by graduates. Within theTop Ten, the schools are not ranked. Nondegree Executive MBA EducationBusiness Week, October 1997:1. Harvard2. Michigan3. Northwestern (Kellogg)4. Pennsylvania (Wharton)5. Stanford6. Virginia (Darden)
  • 15. 7. Columbia8. INSEAD (French school)9. Duke (Fuqua)10. MIT (Sloan)11. Chicago12. IMD (Swiss school)13. North Carolina (Kenan-Flagler)14. Dartmouth (Tuck)15. Indiana Day 1 Marketing Marketing TopicsThe 7 Steps of Marketing StrategyDevelopment
  • 16. The Buying ProcessSegmentationProduct Life CyclePerceptual MappingMarginsThe Marketing Mix and the 4 P’sPositioningDistribution ChannelsAdvertisingPromotionsPricingMarketing EconomicsA scene from the boardroom of AcmeCorporation:
  • 17. DIRECTOR: Every time we do our annualreview of our executives’ salaries, I cringewhen I think that we are paying more to JimMooney, our vice-president of marketingfrom Ohio State, than to our company’spresident, Hank Bufford from Harvard. I justdon’t understand it.CHAIRMAN OF THE BOARD: What don’tyou understand? Without Jim’s sales wewouldn’t need a president—or anyone elsefor that matter!
  • 18. Marketers see the world like the chairmanof Acme. As renowned Professor PhilipKotler of the Kellogg School atNorthwestern teaches, marketing comesfirst. Marketing integrates all the functionsof a business and speaks directly to thecustomer through advertising, salespeople,and other marketing activities.Marketing is a special blend of art andscience. There is a great deal to be learnedin marketing classes, but no amount ofschooling can teach you the experience,the intuition, and the creativity to be a trulygifted marketer. That’s why those with thegift are so highly paid. Formal educationcan only provide MBAs with a frameworkand a vocabulary to tackle marketingchallenges. And that is the goal of thischapter and of the numerous expensive
  • 19. executive seminars conducted by theleading business schools.The top schools prepare their students forexecutive marketing positions—in spite ofthe fact that their first jobs will likely be aslowly brand assistants at large food or soapcompanies. Therefore, the core curriculumstresses the development of full-fledgedmarketing strategies instead of thetechnical expertise needed on an entry-level job out of MBA school.Numbers-oriented students tend to viewmarketing as one of the “soft” MBAdisciplines. In fact, marketers use manyquantitative or “scientific” techniques todevelop and evaluate strategies. The “art”of marketing is trying to create andimplement a winning marketing plan. Thereare literally an infinite number of
  • 20. possibilities that may work. McDonald’s,Burger King, Wendy’s, Hardee’s, and WhiteCastle successfully sell burgers, but they alldo it in different ways. Because there areno “right” answers, marketing classes canprovide students with either an opportunityto show their individual flair, or many hoursof frustration as they try to come up withcreative ideas. Marketing was my favoritesubject. It was fun cooking up ideas fordiscussion. My B-school buddies still kidme about the time I proposed to the classthat Frank Perdue introduce a gourmetchicken hot dog. The Marketing Strategy ProcessThe marketing process is a circularfunction. Marketing plans undergo manychanges until all the parts are internally
  • 21. consistent and mutually supportive of theobjectives. All aspects of a proposal needto work together to make sense. It is veryeasy to get one part right, but an internallyconsistent and mutually supportivemarketing plan is a great accomplishment.It’s a seven-part process.1.Consumer Analysis2.Market Analysis3.Review of the Competition and Self4.Review of the Distribution Channels5.Development of a “Preliminary” Marketing Mix6.Evaluation of the Economics7.Revision and Extension of Steps 1-6 until a consistent plan emergesAlthough there are seven steps, their orderis not set in stone. Based on circumstancesand your personal style, the order of the
  • 22. steps may be rearranged. This chaptercould get bogged down in a morass ofmarketing theory, but to make it practical, Iwill outline the questions and areas thatshould be considered when developing amarketing plan. For expediency, I willconcentrate on product marketing, but thesame frameworks and vocabulary are alsoapplicable to service marketing.I will present the MBA models in the sameseven-step order in which they are taughtat the best schools. This chapter offers ageneric structure to apply to whatevermarketing issue you may encounter. I havenot neglected to use the vocabulary taughtat the schools, so you can pick up on theMBA jargon and speak like a real MBAmarketer. Marketing is an area especiallyrich in specialized vocabulary. With the
  • 23. correct vocabulary, even your mediocremarketing ideas can appear as brilliantones. That may sound funny, but that’s theway ad agencies market their product,advertising.1. Consumer AnalysisConsumer Analysis Market CompetitionDistribution Marketing Mix EconomicsReviseAll marketing plans should begin with alook at the all-important “consumer” and hisor her needs. People do not have the sameneeds or desires. The objective ofconsumer analysis is to identify segmentsor groups within a population with similarneeds so that marketing efforts can bedirectly targeted to them. Starting anywhereelse tends to restrict your thinking and allsubsequent analysis. Several important
  • 24. questions must be asked to find the marketthat will unlock untold marketing riches:What is the need category?Who is buying and who is using theproduct?What is the buying process?Is what I’m selling a high- or low-involvement product?How can I segment the market?What is the need category? Who needs usand why?What is the need or use that your productaddresses? The question may seemunnecessary, but in answering it you mayuncover a potential market for the productthat was previously overlooked. That is whythis question has to be addressed first,
  • 25. before you begin to pollute your mind withconventional thoughts. The people at Arm& Hammer baking soda have done a greatdeal of this type of analysis. They havemade use of their powder in their ownbrand of toothpaste, air freshener, andcarpet freshener. In addition, they profitablyrecommend their raw baking soda powderfor hundreds of uses.Marketing Strategy Development
  • 26. Who is buying vs. who is using theproduct?Buyers many times are different fromusers. Women, for example, make themajority of purchases of men’s underwearand socks. If an advertising campaignwanted to target the buyer of men’s socks,
  • 27. it probably would be inappropriate to buyspace in Sports Illustrated. Determining thebuyer as well as the user provides theessential initial insights to create amarketing plan.What is the buying process?Once you have established the need, andwho is making the purchases, you shouldtry to form a hypothesis on how the productis bought. Marketing research is a primesource of information, but just as valid areyour own observations, investigation, andintuition.Understanding the buying process is criticalbecause it will lead to the possible routes toreach buyers. The buying process includesall the steps that a person takes leading toa purchase. It is also called the adoptionprocess and the problem-solving process
  • 28. by some academics. Some researchers callit a Learn/Feel/Do process. Others call itAIDA for Attention/Interest/Desire/Action. Ihave read extensively on this topic andhave boiled the theories down to five steps.For any particular product, the buyingprocess can include one or all of thefollowing steps:Awareness Information Search EvaluateAlternatives Purchase EvaluateIn the instance of a soap purchase, theprocess would look like this:Smell Body What Should I Use? Soap?Ask Wife for Advice Make Trip to the StoreRead Labels Buy Dial Soap Bathe SmellBody for Odor Buy Dial Soap Next TimeThe steps of the buying process explained:
  • 29. Awareness (Interest, Problem Recognition).“I might need something.” At some point aperson will realize a need, like the need touse soap. Advertising may trigger thatneed. Prestige products such as designerclothes and fragrances trigger desire. Theymeet emotional needs such as love andgroup acceptance. Head & Shoulders preyson the fear of a loss of love and groupacceptance. You need to ask yourself,“How do consumers become aware of myproduct?” “Where are my targets likely tobe exposed to my message?”Information Search. “Sounds good, let mefind out more about it.” People involved inpurchase decisions are confronted withinformation from a variety of sources:Consumer Reports, salespeople, specialtymagazines, family, friends, and local
  • 30. experts. As a marketing manager, you wantyour target market to get as muchfavorable information as possible aboutyour product when and where buyers maketheir buying decisions. For example, storedisplays play that role at the point ofpurchase (POP). Cover Girl Cosmetics hasa display in drug stores to help buyersselect colors. For the same purpose, EstéeLauder has its Clinique ladies indepartment stores to do its talking.Evaluate the Alternatives. Which one isbest for me? This includes not onlyproducts within a category, but substitutesas well. When confronted with the highprices of automobiles, a college studentmay end up buying a motorcycle, a moped,or a bicycle. Depending on the importanceof the product, consumers may seek
  • 31. additional information and advice. Carpurchases often include a trip to the localmechanic or the neighborhood car buff.Placing positive information where yourbuyers are likely to look is one key tomarketing success.At this stage of the buying process themarketing manager would like to identifythe influencers of his target’s buyingbehavior. In the golf industry the club pro isa key influencer in the equipment-buyingdecision of golfers. If you can sell the pro,you can sell to the club’s members.Distribution is also crucial at the evaluationstage of the buying process. If a product isnot readily available, a comparablesubstitute may be chosen just forconvenience or immediacy of need. Coca-Cola and Pepsi’s wide distribution make it
  • 32. tough for any new cola competitor to everbe any more than a fringe brand. Even ifyou crave Dr. Brown’s Creme Soda, youprobably will accept a Coke or a Pepsiwhen you’re thirsty at the beach.The Purchase Decision. This is the bigsale. Even though the decision to buy couldbe “yes,” in certain instances the firstpurchase is only a trial. Adoption of “newand improved” Bounty paper towels as yourregular brand occurs only after a successfultest with those tough spills. With many big-ticket items, such as ocean cruises andappliances, a trial is not possible. In thoseinstances the decision process is moretime-consuming and difficult to makebecause there is more risk involved. It isvery important for the marketer tounderstand risk. Through the use of a
  • 33. number of marketing tools, such asadvertising, knowledgeable salespeople,warranties, and printed materials, purchaserisk can be reduced by offering the buyerinformation explaining what level of performance he or she can expect, as well asproviding a basis of comparison withcompeting products.Evaluate (Postpurchase Behavior). Did Imake a mistake? This conclusion can bereached either on a physical level bytesting the product’s efficacy or on apsychological level by checking for peerapproval. Buyer’s remorse andpostpurchase dissonance are terms todescribe the period of confusion that oftenfollows a purchase. Automobile advertising,for example, is not only targeted atpotential buyers, but also at recent buyers
  • 34. to reassure them that they didn’t screw upwhen they bought a Dodge Caravanminivan instead of a Honda Odyssey.In trying to understand the buying process,the first sparks of a marketing plan can beignited into a tentative idea aboutadvertising or promotion (to be consideredlater in Step 5 of the strategy developmentprocess).Research Can Help to Understand theBuying Process. Consumer research is amajor tool in helping make the buyingprocess theory useful. Research can showa marketing director where he hassucceeded and where his efforts need tobe redirected. For example, if the marketingdirector of The National, a sportsnewspaper that failed in 1991, had
  • 35. conducted a survey that would have shownhim that 50 percent of men were aware ofthe paper, but that only 1 percent had readit, that could have been useful. That findingcould have led the director to increase hisefforts to gain wider newsstand distributionand to give more trial subscriptions.Research is valuable because it can betranslated into tangible marketing actions.Before you embark on research, you mustask yourself:“What specific question do I needanswered?”“How am I going to use the informationonce I have it?”If you haven’t thought through these twosimple questions, you will probably wasteyour time and money. I can assure you thatmany marketing research companies will
  • 36. be glad to help you waste money.Is the product a high- or a low-involvementproduct?As the discussion of buyer behaviorindicates, different products elicit differentpurchase behaviors because of theirinherent importance to the buyer and user.If the consumer feels a high level of “risk” inbuying a product, then it is considered ahigh-involvement product. There areseveral reasons for high-involvementpurchase decisions:High priceThe need for the product’s benefit (e.g.,reliability, as in the case of a pacemaker)The need for the product’s psychologicalreward (e.g., status, love)
  • 37. Stereos, clothing, cars, and professionalservices are examples of high-involvementpurchases. They are usually higher pricedand at times difficult to compare.Determining the differences betweenalternatives makes high-involvementpurchases difficult, especially if the buyer isnot an expert. Thus, the information searchcan be quite extensive. When litigating adamage claim, for example, usually there isno second chance to take the case to trial.Therefore, the choice of a lawyer is a high-involvement selection. With low-involvement products the decision issimpler. For example, if a candy bar isn’ttasty, you can always pitch it and buyanother one.
  • 38. A helpful matrix on page 10 captures thepossible behaviors resulting from theinteraction of the levels of involvement andproduct differences. By understanding thepossible behaviors, you, as a marketer,may be able to take advantage of thisknowledge to sell your product.This academic model does have real-worldimplications for action. A high-involvementproduct, such as a Harley-Davidsonmotorcycle, would appear in the upper left-hand corner of the matrix. The model wouldsuggest that Harley’s marketing effortsshould be geared toward demonstrating itstechnical superiority, but also include anemotional appeal—“buy an Americanclassic”—to engender loyalty.The marketer’s magic is at work when he orshe transforms a previously low-
  • 39. involvement product into a high-involvement one. Athletic shoes are aprime example. Once just functional shoesfor gym class, sports shoes have become astatus symbol for young people and eventhe cause of murder on inner-city streets.The conversion of a low-involvementproduct to a high-involvement product canmake a simple commodity product standout against an undifferentiated field ofcompetitors. There are four generic ways inwhich this can be accomplished.CONSUMER BEHAVIOR MATRIX
  • 40. Adapted from Henry Assael, ConsumerBehavior and Marketing Action, 4th ed.(Boston: PWS-Kent Publishing Co., 1992),p. 100.Link Product to a High-Involvement Issue .Linking Procter & Gamble’s Puritan no-cholesterol cooking oil to a wife’s fear of ahusband’s heart attack is a classic exampleof an advertising ploy.Use Involving Advertising. If the advertisingcreates a value-expressive message about
  • 41. the product or service, then a product canbecome important. Such messages linkvalues, such as social status and love,instead of promoting physical productattributes to differentiate the product fromthe competition. Pepsi tries to link beingmodern and youthful with its products byusing singers in elaborate commercials tosell its soda.Change the Importance of Product Benefits. Products as well as services provide avariety of benefits. If through marketingaction a benefit can be raised to aheightened level of importance, buyers arelikely to become more involved. The beerwars of the 1980s made calories animportant competitive issue. An overlookedattribute—calories—made health-consciousdrinkers more aware of their purchasing
  • 42. decisions, and consequently Miller Litemade out like a bandit.Introduce Important Characteristic toProduct. A marketer can also tinker withsome of the elements of the product itselfto distinguish it. When childproof caps wereintroduced on household cleaners, theinvolvement of parents in this purchasedecision was heightened. The first productswith protection caps stood out on the storeshelves. But once all competitors copiedthe cap, new avenues of differentiationwere needed and the purchase returned toits low-involvement status.Truly low-involvement products often arethat way because a minimum level ofacceptable performance is required. Athumbtack, for example, does not have a
  • 43. very difficult job to perform. No matter whatthe brand, you can’t go too wrong. If thecost of trial is low, such as for a pack ofgum, involvement is difficult to stimulate.Related to involvement is the level ofpurchase planning. Is the purchaseplanned or an impulse buy? High-involvement products are usually plannedwhile impulse products are bought on thespur of the moment. If a purchase isplanned, then a buyer is likely to seekinformation. If not, the proximity of theproduct to the need is very important.Snack foods are an example of impulsebuying. Midday hunger leads to the nearestjunk food.Do I intend to segment the market? Why?How?
  • 44. I skirted around this issue in the buyerbehavior section, but the question “Who isour consumer?” is central to the marketingtask. If you think you have something thatis for everyone, then a mass marketstrategy is appropriate. If your productsatisfies the masses, then feed it to them. Ifnot, you must choose a segment orsegments of the market to target.Segments are homogeneous groups ofsimilar consumers with similar needs anddesires. For instance, Coca-Cola uses amass-market approach to get everyonedrinking the “real thing.” Orangina, aspecialty soda, appeals to a more narrowlydefined market segment. It’s priced higherand its bottle is shaped differently.Orangina appeals to a special segment ofthe soft drink market.
  • 45. Segmentation of the market serves thefollowing functions:To identify segments large enough to serveprofitably.To identify segments that can be efficientlyreached by marketing efforts.To help develop marketing programs.By having a definite segment in mind, youcan effectively aim and efficiently executeyour marketing activities to yield the mostsales and profits. Without a target, you riskwasting marketing dollars on disinterestedpeople. There are four major segmentationvariables used in segmenting consumermarkets:
  • 46. - Geographic- Demographic- Psychographic- BehavioralGeographic Segmentation. Divides themarket by country, state, region, county,and city. The federal census lists 310Standard Metropolitan Statistical Areas(SMSAs) to define the major geographicpopulation centers of the United States.Arbitron, a large media research firm, hasdefined a similar measure to capture the210 major television markets of the country,called Areas of Dominant Influence (ADIs).A. C. Nielsen, a competitor, has a similarmeasure called Designated Market Areas(DMAs).
  • 47. Demographic Segmentation. Divides apopulation based on the followingmeasurable variables to reach ahomogeneous group of people:Age—Different generations’ different wantsand needsSex—Gender use and buying patternsIncome—The ability to purchaseMartial Status—Family needsFamily Life Cycle—Starting out, emptynesters, etc.Education/Occupation—An indication of thesophistication of the consumerEthnicity, Religion, and Race—Particulartastes and preferences
  • 48. Psychographic Segmentation. Divides themarket by psychological differences:Life-style—Activities, interests, andopinionsPersonality—Conservative, risk-taking,status-seeking, compulsive, ambitious,authoritarian, gregarious. (People mayhave different hot buttons that advertisingcan try to trigger.)Psychographic segmentation is difficult.Personality variables are tougher to identifyand quantify than demographics, but theycan be very valuable.
  • 49. Behavioral Segmentation. Divides themarket by observable purchase behaviors:Usage—Amount of use, manner of use,benefits soughtPurchase Occasion—Gift, vacation,seasonal, etc.Brand Loyalty—Loyalty to one productindicates receptiveness to others.Responsiveness to Price and Promotion—Some groups respond to specialmarketing efforts more than others.Housewives use more coupons than singleprofessional women.Marketers must not only select the “right”group of variables but also decide howmany to use. The correct number of
  • 50. “useful” variables will identify the mostaccessible and receptive target, not themost specific. For example it is possible todescribe a target segment for Corvettes asbrown-haired, male, twenty-five to sixty-fiveyears old, with income over $50,000.However, the ability to target just brown-haired men with effective advertising islimited and its usefulness would bedubious. Is brown hair a necessarysegmentation variable? There are nomagazines exclusively targeted to brown-haired males. Besides, blond andredheaded men may also be a reasonablemarket for Corvettes. You should use thefollowing criteria to evaluate possiblemarketing segments:
  • 51. Measurability—Can you identify thesegment? Can you quantify its size?Accessibility—Can you reach the segmentthrough advertising, sales force ordistributors, transportation, orwarehousing?Substantiality—Is the segment largeenough to bother with? Is the segmentshrinking, maturing, or is it a growingsegment?Profitability—Are there enough potentialprofits to make targeting it worthwhile?Compatibility with Competition—Are yourcompetitors interested in this segment? Arecompetitors currently investigating it or is itnot worth their trouble?Effectiveness—Does your company havethe capabilities to adequately service this
  • 52. segment?Defendability—Can you defend yourselfagainst a competitor’s attack?With that theoretical background, here’s asample demographic profile of gourmetcoffee buyers that marketers actually use:Twenty-five to fifty-four years oldCollege educatedProfessional or business executiveemploymentChildless householdsHousehold incomes greater than $50,000This “yuppie” market segment ismeasurable, accessible, large, and
  • 53. profitable. Consequently, many large coffeecompanies continue to target it.Even in markets that appear hopeless,there may be a segment that othersoverlook. Xerox controlled 88 percent of thecopier market in the 1970s. The majority ofits sales came from large and medium-sized units. But by 1985, Xerox had lostmore than half of its market share. Whathappened? Xerox ignored the small-copiermarket. Thousands of small companieswith light copy needs had to run to the localcopy shop every time they had a copy job.Canon, Sharp, and Ricoh seized thismarket by selling a smaller and lessexpensive copier. With a foothold in smallcopiers, the Japanese competitorsproceeded to topple Xerox in the large-copier segment of the market.
  • 54. Consumer analysis serves to “prime thepump” when you need to form acomprehensive marketing strategy. Do itfirst so as not to stifle your creativity withthe quantitative analysis you will perform aspart of the strategy developmentframework. On a first pass, you can makean “intuitive” choice of a target segment.After the other steps are completed it canbe altered to fit an evolving marketingstrategy.2. Market AnalysisConsumer Market Analysis CompetitionDistribution Marketing Mix EconomicsReviseWhile segmentation analysis focuses onconsumers as individuals, market analysistakes a broader view of potentialconsumers to include market sizes and
  • 55. trends. Market analysis also includes areview of the competitive and regulatoryenvironment. By closely examining themarket, a marketing manager candetermine if the segment selected is worththe trouble of a targeted marketing effort.MBAs ask three important questions toevaluate a market:What is the relevant market?Where is the product in its product lifecycle?What are the key competitive factors in theindustry?What is the relevant market?The easiest mistake to make is to believethat your relevant market includes the totalsales of your product’s category. In
  • 56. between the first and second years of myMBA education, I worked for aninternational trading company. Iinvestigated the possibility of selling aMexican gourmet ground coffee in U.S.grocery stores. It would have beenmisleading for me to assume that all coffeesales were in my relevant target market.Approximately $11 billion of coffee wassold in the United States in 1990. However,60 percent of that total was sold in stores,while the other 40 percent was sold to theinstitutional markets, including restaurantsand vending machines. That left me with aretail market of $6.6 billion.But within that larger coffee market therewere additional sub-markets to investigatebefore arriving at my final relevant market.The gourmet coffee market accounted for
  • 57. $750 million, or 11 percent of the retailmarket’s sales. Within the gourmet coffeemarket, only 60 percent of the coffees soldhad no artificial flavorings. My Mexicancoffee had no additives and the producerrefused to artificially flavor his coffee.Therefore, my relevant market was furtherreduced to $450 million. But of that marketslice, only 55 percent was sold insupermarkets. That left me with a $248million market. That was my relevantmarket.Once a market segment is identified, youhave to ask if it is large and accessibleenough to justify your marketing effort. Ifthe answer to that question is no, then youhave what is called a “makable” product,but not a “marketable” one. Onlymarketable products make money.
  • 58. These questions are difficult to answer andinvolve marketing research. If it is a newproduct, the answers will not be readilyavailable. Test markets may have to beused to obtain that information. This stepmay lead to further segment investigation.The growth and decline of consumersegments within a market should also benoted. When the market is growing, futuresales growth can come from new users orexisting customers. If the pie is shrinking,any sales growth has to come out of yourcompetitors’ hide, and they’ll fight you formarket share! Following the demographictrends to attract a growing senior citizenmarket, Lederle Laboratory, themanufacturer of Centrum vitamins, made avery minor reformulation in 1990, andsuccessfully introduced its “Silver” formula.
  • 59. Where is the market in its product lifecycle?Markets can be characterized by the stagethat they are at in their product life cycles(PLC). Instead of being merely a factor oftime, the PLC describes how a product’ssales grow as new segments becomeaware and begin buying it. Cellular phoneservice began in the early 1970s with fewerthan ten thousand users. But it wasn’t untilthe 1990s, when the prices dropped andmany could afford a unit for their cars, thata multisegment market of over six millionusers emerged.The PLC concept is important because theprocess of diffusion or adoption by thepopulation has major implications for how aproduct is marketed. Each productdevelops its own unique PLC as it matures.
  • 60. Understanding the PLC can give you anMBA insight that your competitors maylack.The four generic stages of the PLC andtheir implications for action are:Stage 1: Introduction, “What is it?”Awareness and education are needed. Ifpossible a trial is important. Highadvertising costs may be incurred to get theword out. Some vendors opt for anexclusive distribution of their products in afew select outlets at first. Initiallycompanies make frequent product changesas customers’ needs become known. Thefirst buyers are called the innovators,followed by the early adopters. They freelytake purchase risks because theirpersonalities or pocketbooks allow them to
  • 61. do so. When companies introduce newproducts, managers must make difficultpricing decisions because there isfrequently no basis for comparison. Thelevel of initial prices and profits has greatimplications regarding the outcome offuture battles with competitors as well asyour ability to perform additional researchand development (as with products likehigh-definition TV and DVD).Stage 2: Growth, “Where can I get it?”Education is still important, but at this stagecompetition is intensified. The earlymajority becomes interested. As moreconsumers become familiar with a productthey examine the new models to decidewhich to buy, not whether they should buy.When buyers get to the store they start
  • 62. comparing features. To make the productmore accessible, marketers often choose aselective distribution to gain a greaternumber and variety of outlets. At this stageit is important to boost your sales volumeahead of the competition in order to reducecosts through production and advertisingefficiencies. This helps a company gain thecompetitive advantage in the next stage ofthe PLC (e.g., palm organizer).Stage 3: Maturity, “Why this one?” At thisstage the late majority of the mass marketbuys. Because people are accustomed tobuying the product and the differences arefew, brand loyalty plays a dominant role.Price competition often becomes heated instable markets because additional marketshare comes directly from your
  • 63. competitors. The product’s features thatwere so important in the growth stage havebecome standardized. Because there isless differentiation on product attributes,advertising is used as a vehicle todifferentiate products. Marketing managerstry to segment their target market as muchas possible to meet specific unmet consumer needs. In mature marketscompetitors are ferreting out all possiblesegments. All possible channels ofdistribution are also considered using amass market distribution strategy (e.g., CDplayers, VCRs).The Product Life Cycle
  • 64. Stage 4: Decline, “How much?” As aproduct ages in its PLC, it is likely that itscompetitors offer similar products. Even themost timid consumers, the laggards, find itsafe to buy the product at this late stage. (Ifit does cause cancer, the FDA usually hasfound out by now.) Consumers turn a deaf
  • 65. ear to advertising because they know thatall competing products are the same. Atthis stage many companies focus theirefforts on reducing price if competitionremains, or slowly increasing prices if thecompetitive field thins. Trade relations arekey to staying on the retail shelf at thispoint, because without the excitement ofnovelty, distributors and retailers wouldrather allocate space to newer andpotentially more profitable products. Theeffort to sell the trade is popularly calledrelationship marketing (e.g., black-and-white TVs, phonographs, and cassettes).With some products the maturity phasedoes not necessarily mean death. Productscan be reinvigorated after a period ofmaturity and a new growth phase canbegin. Baseball trading cards underwent
  • 66. such a revival, encouraged by Topps Inc.’smarketing efforts in the 1980s, and losttheir luster in the 1990s.In some cases, lingering death throesproduce large profits for the lastmanufacturer. In the vacuum tubebusiness, which supplies electronic tubesfor old TVs, radios, and other equipment,Richardson Electronics is the survivor in anindustry once dominated by GE, RCA,Westinghouse, and Sylvania. Using an endgame strategy, the remaining producerscan extract large profits from customerssince they have nowhere else to go for theirreplacement parts.What are the key competitive factors withinthe industry?The basis of competition in each industry ormarket tends to be different. It has a major
  • 67. impact on how a business attacks itsmarket. There are five major keycompetitive factors that constitute thebattleground in most industries:- Quality- Price- Advertising- Research and Development- ServiceIn the fast food industry, for example,intensive advertising and promotion arekey. In industries providing raw materials toothers, price and service are key. In myinvestigation of the coffee industry, I foundprice and quality to be the basis ofcompetition. When developing a marketingplan, you may want to try to change thebasis of competition to one that favors yourfirm, but the key underlying competitive
  • 68. factors cannot be ignored.3. Analysis of Your Company Versus theCompetitionConsumer Market Competitive AnalysisDistribution Marketing Mix EconomicsReviseBy this stage the marketer has preliminarilychosen a consumer segment toward whichto direct his or her efforts. Now, a plan tobeat the competition must be developed.You need to look at yourself and at thecompetition with the same level ofobjectivity. What are your advantages?What things do you do well? (MBAs callthem core competencies.) What are yourweaknesses? How can your companycapitalize on its strengths or exploit yourcompetitors’ weaknesses? The following
  • 69. questions help to flush that out.What is your company good at and what isthe competition good at?- Distribution (Frito-Lay)- New Product Development and Introduction (3M)- Advertising (Absolut vodka)Who are we in the marketplace?- Market Size and Relative Market Share- Financial Position- Historic Performance and ReputationWhat are our resources versus those of thecompetition?- People- Technology, Research- Sales Forces- Cash
  • 70. - Trade Relations- ManufacturingBarriers to entry to new competitors in amarket play an important role in assessingthe competition. Barriers are conditions orhurdles that new competitors have toovercome before they can enter themarket. The availability of cash andspecialized knowledge are such barriers.The pharmaceutical industry, for example,is dominated by a few companies. To be aplayer, a company needs a large salesforce, research labs, and a large bankaccount to pay for it all. Because of thesebarriers, most small companies team upwith large ones if they have a promisingnew drug to peddle.If in an industry the barriers to entry arelow, the playing field becomes very
  • 71. crowded. Savvy marketers should plan forthat eventuality by trying to form amarketing strategy that new competitorscannot easily copy. This is more fullydiscussed later in the book in the Strategychapter.During my coffee investigation, I looked atwhat my company had to offer. It didn’thave much. It didn’t have any experience inthe United States. We lacked distribution,advertising expertise, a reputation, andcash. The only thing my Mexican employerhad to offer was quality packaged coffee.What could a small competitor do againstFolger’s and Maxwell House coffees? Aftermuch questioning, and feeling a little ill, Ihoped that there might be a large foodcompany that would like to enter into a jointventure. We would supply the coffee and
  • 72. the partner would do the distribution andmarketing. We could piggyback, not unlikewhat small pharmaceutical companies do,recognizing that some profit is better thannone.What are the market shares of the industryplayers?Many tracking services are available forconsumer products such as Selling AreasMarketing Inc. (SAMI) and A. C. Nielsen.Checkout scanners and warehousetracking collect supermarket sales data.However, for industrial products, such asmanufacturing equipment, the informationis less accessible. Trade associations are agood source.The shift of share over time is extremelyimportant. In the battle for “instant” coffeesales in the grocery store, for example, the
  • 73. top three competitors controlled 95 percentof the market in 1989, up 5 percent from1986. They were Kraft Foods (37 percent),Nestle (34 percent), and Procter & Gamble(24 percent). Little was left for a newentrant.Market share leverage is a key concept toconsider when examining market shareswithin an industry. The companies withlarger market shares relative to theircompetition usually enjoy higher profits.Larger competitors can produce morecheaply on a per-unit basis because theycan spread their costs over more units. Asmaller competitor cannot afford to spendas much on either research or moreefficient equipment, because the smallersales volume cannot support the burden. IfI had been charged with a new instant
  • 74. coffee to sell, I would have had toreconsider entry into the declining instant-coffee market dominated by bigger, lower-cost competitors. Fortunately for myMexican coffee’s entry, in 1989 18 percentof the “ground” coffee market wascontrolled by smaller competitors. And thatshare had increased from 16 percent in1986. This constituted a far more favorableenvironment for a new entrant such as myMexican ground coffee.How does my product perceptually mapagainst the competition?The perceptual mapping technique is agraphic way to view and compare yourproduct against the competitors’. Acommonly used grid is price and quality,but many others are possible and useful.Maps are another MBA technique to
  • 75. generate ideas for marketing for yourproduct, and perceptual maps mayhighlight an unserved market segment byshowing how the consumer perceivescompeting products, regardless of thephysical reality of performance.Perceptions are paramount in marketing,just as they are in politics. In the papertowel industry, for example, towel strengthand decorator appeal are very important.As an example, using my own judgment, Ihave created a “hypothetical” map on page23. Notice that Bounty found itself a veryprofitable market segment by providingstrength and a pretty pattern.By visualizing how your product mapsversus the competition, you may gain aninsight into how to market your existingproduct, make product changes, or add
  • 76. additional products in a comprehensivemarketing strategy.If your company has many products withina category, then you are said to have depthof line. In the paper towel market no oneproducer dominates the category. But overin the dog food aisle, Ralston’s depthchokes the shelves with Dog Chow, PuppyChow, HiPro, O.N.E., Lucky Dog, and atleast six other brands.If your company has many products in avariety of product classes, you are said tohave breadth of product line. Kimberly-Clark has a wide breadth of paper productsin several categories: Hi-Dri paper towels,Kleenex tissue, Kotex sanitary napkins, andHuggies and Pull-Ups diapers. Depth andbreadth of product lines can be cleverlyused in a blocking strategy to prevent
  • 77. competitors from gaining access to thechannels of distribution. If they are not onthe shelf, your competition can’t make anysales.Perceptual Mapping Paper Towel Brands (Hypothetical)
  • 78. In the dog food industry, competitors foundother ways around Ralston to reach doggieowners. Iams sold $350 million ofEukanuba brand premium dog food in 1996to breeders and specialty stores. In the
  • 79. same year Hill’s Pet Products, a division ofColgate-Palmolive, pushed $750 million ofScience Diet pet food and other productsthrough veterinarians’ offices.4. Review of the Distribution ChannelsConsumer Market CompetitionDistribution Analysis Marketing MixEconomics ReviseMarketers speak of the avenues to theconsumer as the channels of distribution.There are often many ways of reachingyour customers, as described with dog foodsales. Distribution channel analysis iscritical, because the choice of channelinfluences the price you can charge, and,consequently, the profit margins that youmay enjoy. Three questions should beasked to provide you with a basis for yourdistribution decision:
  • 80. How can my product reach the consumer?How much do the players in eachdistribution channel profit?Who holds the power in each distributionchannel available?How can my product reach the consumer?In the case of many mail-order catalogs,there is a direct link between the marketerand the final consumer. A catalogmanufacturer of clothing has a direct pulseon sales, returns, pricing, and consumertastes. As manufacturers of grocery items,brand managers are distanced from thebuyer. Cereal, for instance, must gothrough wholesalers and retailers beforereaching the consumer. Those middlemenare called channel intermediaries. As a
  • 81. strategist, the marketing manager mustoutline all the paths to the consumer todevelop a plan.Commonly used channel intermediaries tothe consumer are:- Wholesalers- Distributors- Sales Representatives- Sales Forces- RetailersHow do the players in each distributionchannel profit?As I mentioned, it is very helpful tounderstand all the paths to the consumer inorder to know all the possible ways tomarket your product. Take the time to drawthem out on paper. A channel sketch canalso give you the insight into the retail pricethat must be charged to make a profit.
  • 82. Everyone who touches the merchandisetakes a cut, which is called their margin.Participants in the distribution chain aresaid to “take margin” from themanufacturer. As a manufacturer of aproduct, you do not “give” the channelmargin; there is no charity involved.Channel participants in most industriescalculate their cut as a markup on sellingprice. Canadian and some U.S. drug firmsuse a markup on cost, but they are theexceptions. The selling price is not theultimate retail price, but the price at whichone intermediary sells goods to the nextintermediary in the chain. The retail price iswhat a consumer pays.Because of my experience in the coffeeindustry, I will use coffee retailing todemonstrate the economics of the channels
  • 83. of distribution. At each level of the chain,the intermediary buys the coffee from theprevious level and takes a margin based onthe sales price to the next level. The marginis not based on cost.This is how one dollar’s worth of coffeebeans, in my example, can reach theconsumer at a price of six dollars. At eachlevel, the channel participant adds valueand incurs costs by either roasting,grinding, and packaging the coffee beans;promoting the brand; or distributing andshelving the packaged coffee for theconsumer. I have outlined on page 27 whatI estimated were the channel economics in1989 for Maxwell House’s gourmet Private
  • 84. Collection coffee.At each level in the distribution channel, theparticipant performs its function, takes itsmargin, and sells to the next participantcloser to the consumer. If a coffeeprocessor, such as Kraft Foods, believesthat its gourmet Maxwell House PrivateCollection coffee brand must retail at $4.00per pound rather than $6.00, then theeconomics of the chain must change. Let’swork backward through the chain to see itseffect on the prices charged at each level.Selling Price × (1 Markup %) = ThePreceding Distribution Level’s Selling PriceWorking backward through the distributionchain:$4.00 Retail Price to Consumer × (1 .23Retail Markup) = $3.08
  • 85. $3.08 Wholesaler Price to Retailer × (1 .09Wholesale Markup) = $2.80$2.80 would be Kraft Foods’ (theProcessor’s) Price to WholesalersAt the $4.00 price, Kraft Foods’ brandmanager must ask if $1.75 ($2.80$1.05)per pound is a sufficient margin to covercosts and provide an adequate profit. If theanswer is no, the brand manager mustreexamine the marketing plan’s channelmathematics. Because marketing strategyis a circular process, another price,manufacturing process, or cost may haveto be altered. Such changes could affect allthe other elements of the plan.The relative power of the channelparticipants can dictate pricing decisionsbased on the economics of the channelchosen. In Kraft Foods’ case, the brand
  • 86. manager could have opted for the lower$4.00 retail price in the grocery store.However, he chose $6.00 to yield hisdesired profits.Kraft Foods decided to use an alternativechannel in addition to grocery stores. Kraft“bypassed” the grocery trade’s middlemenand sold its Gevalia and Garraway coffeebrands directly to coffee lovers by mailorder at a price over $8.00 per pound. Withmost products there are usually a variety ofways to reach the consumer. Each channelhas its own channel margin mathematics.By understanding the math you are betterable to make a choice of channel.Who has the power in the channels?The question of channel power is verycrucial in selecting where to sell. If yourproduct is unique and in demand, then the
  • 87. manufacturer generally has the power tooutline the terms of the relationship. If not,the channel’s intermediaries will be able todictate the terms to take as much marginas possible.Channel of Distribution for Maxwell House’sPrivate Collection Coffee with ChannelMargins and Prices
  • 88. In the grocery trade, the power of thechannel has shifted from the manufacturersto the supermarket chains. As smallergrocery chains consolidated into largersuper chains in the 1980s, the largerchains’ management realized that they heldthe prized real estate, “shelf space.” Eachstock keeping unit (SKU) on the shelf takesspace. Each product must be tracked,shelved, and inventoried. (When Mazolacooking oil produces three sizes, it takes upthree (SKUs.) With a finite amount of storeand warehouse space, the shelf real estatehas become valuable, and retailers want tobe paid for carrying each SKU. Marketerseven diagram their shelves like architects indrawings called planograms and fight overbest placement.
  • 89. Packaged goods companies, large andsmall, must often pay slotting fees to thechains to reserve their “slots” on theirshelves for both new and existing products.In the 1970s the packaged good giantscould force their products on the trade.When there were many smaller grocerychains, Procter & Gamble and Kraft Foodscould play one chain against another bythreatening to withhold their popularproducts. That is no longer the case.Unfortunately, slotting fees can run intomillions of dollars for a new productintroduction. Therefore, in practice, slottingfees bar smaller competitors from selling inthe supermarket. A maker of an excellentpizza in the Midwest that I knew failed toget off the ground because it could notafford the bribes necessary for space.
  • 90. Slotting fees are a “hot topic” in retailing.Feel free to interject this topic into MBAconversation as often as you like.5. Development of the Marketing MixConsumer Market CompetitionDistribution Plan the Marketing MixEconomics ReviseBased on judgments developed in theanalysis of the consumer, the market, thecompetition, and the distribution channels,the marketing manager must make a set oftangible decisions. MBAs call it the actionplan. Marketing managers choose what mixof marketing efforts should be made. Themix is commonly referred to as the Four P’s of marketing.The development of the marketing mix isan evolutionary process whose goal is an
  • 91. internally consistent and mutuallysupportive plan. That cannot beoveremphasized. Tinkering with one P inthe mix generally means the marketingstrategist must alter all the other P’s insome way, because one P affects theothers.The Marketing Mix
  • 92. Product Place Promotion PriceProduct Decisions
  • 93. How does my product fit with my otherproducts?How will I differentiate my product?How does the product life cycle affect myplans?How does the product fit with my existingproduct line?This question tries to identify areas ofsynergy among your products, or uncover aconstraint on your activities. For example, if“The Dependability People” at Maytagadded dishwashers to their line of clotheswashers and dryers, the product, thecustomers, and the retailers for thedishwashers would be shared with theirexisting line. There would be a fit with thisline extension. But if Maytag wanted to sellpersonal hair dryers, the fit would bequestionable.
  • 94. How will I differentiate my product?Differentiation is a broad issue that includesany way that a marketer can distinguish hisproduct from the field. Consequently thereare many ways to do it.- Feature—Capabilities- Fit—Tailoring- Styling—Functional, visual- Reliability—Warranties, return policies- Packaging—Color size, shape, protection- Sizes—Clothing, appliances, computers, and luggage sizes- Service—Timeliness, courtesy, accuracy- Brand Naming—LabelingIf Ralph Lauren had used his real name,Ralph Lifshitz, he would have foregone thepsychological benefits derived from hisRalph Lauren’s Polo label on $1.3 billion inclothing, cologne, and bedding in 1998.
  • 95. Lifshitz somehow fails to convey the imageof English aristocracy.In many cases the so-called brand equity ofone product can be transferred to newproducts using a brand or line extensionstrategy that differentiates it from the pack.Kraft Foods has chosen to place the Jell-Obrand name on its new pudding and icecream treats. The Jell-O brand bestowsupon the new products all the goodwill andbrand recognition (brand equity) that Jell-Oearned over decades. It would take manyyears of expensive advertising to establishthe brand equity of the Jell-O brand.Accordingly, almost 70 percent of thetwenty-four thousand new productintroductions since 1987 were line andbrand extensions. If stretched too far, abrand’s equity can be diluted and its
  • 96. effectiveness with consumers devalued.The choice of any one of these productdifferentiation techniques affects the entiremarketing process, as it lays thegroundwork for your promotional efforts. Aproduct can be differentiated from thecompetition by creative advertising andpromotion, even if competing products arephysically identical.Perceptual maps and positioning can helpto differentiate the product. All the productattributes mentioned affect the positioningof a product in the marketplace. Themarketer can always call upon hiscompany’s product engineers to develop aproduct’s physical characteristics if theprofits justify it. As my perceptual map ofpaper towels indicated, consumers havespecific needs within a product class and
  • 97. they perceive each product differently. Themarketer’s job is to uniquely position theproduct (using a perceptual map as a guideif desired) to earn its place in the market.That place is often called a product’s nichein the market. As pictured in the perceptualmapping of paper towels, James River’sBrawny brand is positioned as the tough,durable towel for really dirty cleanups.Hopefully the brand manager will choose aniche that will yield the most sales andprofits by targeting a market segment hisproduct serves best. Positioning isinexorably tied to the market segmentselected through your consumer andmarket analysis.How does the product life cycle affect myplans?
  • 98. Based on the point in the product life cycle(PLC), different aspects of the productbecome more important in the competitivebattles. The previous discussion of the PLCnoted that product features are extremelyimportant to differentiate products in thegrowth phase, while branding isincreasingly more important in the maturityphase. The emphasis on multiplay featureson compact disc players, for example,currently indicates the growth phase of thePLC. In the mature cassette deck market,the battles over auto reverse and Dolbynoise reduction have already been playedout. Whatever the choices for the product,product decisions will have a definite effecton the other P’s of the mix.
  • 99. ProductPlace Promotion PricePlace of Sale Decisions: Where to Sell?In your review of the distribution channels,the goal was to determine what avenuesexist and what margins are available. Atthis stage, having made product decisionsand a choice of target market, the marketerhas to choose an appropriate channel to fitwith the product and the intended buyers.What distribution strategy should I use?On what basis should I choose a channel ofdistribution?What type of distribution strategy should Iselect?- Exclusive—Sell in only one outlet in each market
  • 100. - Selective—Sell in only a few outlets in each market- Mass or Intensive—Sell in as many outlets as possibleThe place of sale affects the perception ofyour product. The choice of distribution isan evolving process that matches theproduct’s intended diffusion along theproduct life cycle, as described in themarket analysis passage. A distributionstrategy can differentiate your product fromthe crowd. For example, if a new designerchooses to sell exclusively at NeimanMarcus, it gives a certain cachet to theproduct. Consumers tend to perceivecertain attributes in a product, such asstyle, quality, and price, based on the pointof sale. The same designer may choose toselectively sell in only better department
  • 101. stores to provide greater initial salesvolume. The California marketer of carwindow sun shields had no such concern,and selected a mass distribution strategy.The company wanted to distribute thecardboard shade as widely and quickly aspossible. That choice made sense sincethe shades, unlike designer clothing, didnot have any status appeal and could beeasily copied and manufactured.Each of these distribution methods placescertain responsibilities upon themanufacturer and the retailer. By choosingto be selective, the manufacturer may be“obligated” to provide high quality, goodservice, and possibly cooperative payments(co-ops) for promotional support. Whenmanufacturers share the costs ofadvertising with retailers, that is called
  • 102. cooperative advertising.In distribution relationships involvingmanufacturers’ incentives, the retailer isalso obligated. Retailers may be “obliged”to pay special attention to the product bygiving it preferential placement, specialpromotion, display, and sales attention. Ifthose obligations are not met, the contractis breached and the relationship can besevered. In Ralph Lauren’s case hebelieved that his Polo clothing line was sounique that he became the first designer todemand separate boutique space indepartment stores. Ralph provided theimage and the margins sought by retailers.The retailers were in turn obliged to provideRalph Lauren with special placement andselling efforts.
  • 103. Which channels of distribution to choose?It depends…on a variety of factors. Thereis usually more than one choice. However,if a channel is integrated into a mutuallysupportive and internally consistentstrategy, many choices can potentially besuccessful. Three factors should serve as aguide to make a selection.Product Specifics. Another factor toconsider is the level of attention needed forthe sale. This is related to the level ofcomplexity of the product, the newness, orthe price. The product may indicate a needfor your own sales force despite the costs.On the other hand, products such as candyand soft drinks are sold through a series ofwholesalers and distributors beforereaching the store shelves. These productsare simple and do not require direct control
  • 104. by the manufacturer over the presentationand sale.Need for Control. The ability to motivate thechannels to carry your product effectivelyand appropriately enters into the placementdecision. The further the manufacturer isremoved from the consumer withdistributors, wholesalers, and jobbers, theless control the manufacturer has over howa product is sold. Pharmaceuticalcompanies usually have their own salesforces, also called captive sales forces, thatare thoroughly trained to provide credibleinformation to doctors. If Merck or Pfizerhad to rely on an independent sales forcethey would not have absolute control overtheir training or conduct in the field.Margins Desired. The analysis of thechannels of distribution helps to determine
  • 105. the potential profits available. Where arethe margins taken at each level? Can yourcompany deliver the product through thechannels at a competitive price and stillreserve enough margin for itself? Based onthe available margins, channel decisionscan be made. In the case of radardetectors, Cincinnati Microwave opted tosell directly to the public through magazinedisplay advertising. They chose not to sellthrough electronics stores or other generalmerchandisers. Their managementbelieved that the technological superiorityof their Escorts and Passports would helpthe units sell themselves. CincinnatiMicrowave chose to capture the entire retailmargin and to cut out all the middlemenwho typically distribute and sell electronics.Their strategy faltered because they failedto maintain their product’s technical edge.
  • 106. Product PlacePromotion PricePromotional DecisionsPromotion includes all the advertising andselling efforts of the marketing plan. Goalsetting is paramount in developing apromotional campaign. You need to knowthe mission you want to accomplish beforeyou can begin to draft or spend thepromotion budget. The ultimate goal ofpromotion is to affect buyer behavior;therefore the desired behavior must bedefined. Different products, at differentstages of the PLC, with different levels ofinvolvement and complexity, requiredifferent promotional efforts to performdifferent missions. The promotional missionchosen for your product must be consistentwith the buying process outlined in your
  • 107. consumer analysis.Buying ProcessPromotional MissionAwareness Inform about product, prompt aneed messageInterest Provide compellingmessage, solve a need messageTrialMotivate actionRepurchase Cue to buy,increase usageLoyalty Reinforce brand orimage, special promotionsPush or Pull Strategy? As with distribution,promotional efforts should be guided by astrategy. Pull strategies are those effortsthat pull buyers to the outlets that carryyour product. TV pitches that instructviewers “to ask for Perdue chicken byname at your local grocer” pull consumersto the stores that carry it. Another importantmission of promotion is to encourage the
  • 108. distribution channels to stock and sell aproduct to consumers. Such efforts are apush strategy. Beer distributors, forinstance, spend a great deal of their timetrying to court bar owners to stock andpromote their brew on tap. Most plans havean element of both push and pullstrategies. In the beer industry they spendheavily to advertise the brand as well as togain greater bar distribution.To pull buyers to a store or to push thedistribution channel to stock and sell, thereare five general categories of promotionalefforts:AdvertisingPersonal Selling
  • 109. Sales PromotionPublic Relations and PublicityDirect SellingAdvertising. Advertising takes many forms:television, radio, outdoor (billboards),magazine, and newspaper. Two importantthings to keep in mind are your intendedmission and the quantitative measurementof exposure required to accomplish it.Please pay attention to the followingmeasurement vocabulary. This is what youpay for when you buy advertising. Thetendency for the uninitiated is to listen tothe ad world’s babble, not understand it,and buy their wares anyway. Buyingadvertising is just like buying marketingresearch—know what and why you are
  • 110. buying—buyer beware.Reach and frequency are key quantitativemeasurements of media goals. Reach isthe percentage of the target market whosee and hear your promotion oradvertisement. Frequency is the number oftimes they saw or heard it. Marketers referto the number of times a person is exposedto a message as the total impressionsmade on that audience. Because of thebuying behavior associated with differentproducts, different mixes of reach andfrequency are required to induce purchase.When multiplied, Reach X Frequencyequals a measure called gross rating points(GRPs). Add the GRPs together and youget total rating points (TRPs). GRP andTRP are the measures by which radio, TV,and outdoor advertising is sold and
  • 111. purchased.The desired demographics andsegmentation variables of the audiencesdelivered also enter prominently into theequation. A TV station’s regional golfprogram that delivers active, middle-agedgolfing males with incomes over $100,000in the Southwest could be efficiently usedto advertise a variety of products. A TVprogram that attracts a muddled mix ofdemographic audiences is less valuableper audience member. Even if you have theright media vehicle, scheduling is key inreaching your target.High GRPs do not guarantee sales. Themessage delivered is also a keydeterminant. When advertising people referto the message, copy (wording), or layoutof advertising, they call it the creative, a
  • 112. noun. Ad agency people who develop theideas are called creatives.Magazine and newspaper advertising ispurchased based on the size andsegmentation variables of their circulations.Magazines have a longer shelf life, butnewspapers deliver a much moreimmediate and focused geographicreadership which is best for salepromotions. Both of these print audiencesare bought on a cost per thousand (CPM)readers basis. A comprehensive listing ofmedia and mailing list prices is provided bySRDS (Standard Rate & Data Service), in aseries of telephone book-sized volumes.A competitive measure of media is share ofvoice. Using this measure, an advertisercan target a certain percentage of mediaspending by all competitors within a
  • 113. product category. Advertisers believe thatto have an impact through the competitivemedia clutter and noise, the relativespending level is just as important as theabsolute dollars spent.Through the clutter, it would have beenfutile to run a TV ad to promote the tinycoffee brand that I managed during mysummer internship. A small competitor hadno chance against the likes of Procter &Gamble, Kraft Foods, and Nestlé, whotogether spent over $200 million inadvertising in 1999. Any affordable adwould have been drowned out by thegiants.Remember, each medium has its strengthsin reaching people. Some are moreselective than others. Marketers want toreach their intended targets as efficiently as
  • 114. possible to induce the desired buyingbehavior.Personal Selling. Marketers choosepersonal selling when they need to makedirect contact with the buyer. A salespersoncan personalize your message to fit thebuyer’s needs and situation, and can fieldobjections and questions in this interactiveprocess. This avenue is generally the mostexpensive element in any marketing mixbecause of the high cost of labor andcommissions paid.Managers of products that are new,complex, or expensive find that the benefitsof personal selling often outweigh their highcost. Because some target markets areinaccessible by other media vehicles,personal selling is sometimes the only
  • 115. means to reach consumers. Waterpurification systems, pharmaceuticals,encyclopedias, copiers, and industrialproducts widely utilize personal selling intheir marketing mixes.Current theory holds that personal selling isa problem-solving and consultationprocess. Professor Derek A. Newton of theDarden School at the University of Virginiasaw personal selling as having evolvedover the years in four stages: Music Man,Animated Catalog, Magic Formula, andProblem Solver. Before World War I it wasbelieved that the “Music Man” approach toselling was the key to success. It was thesalesperson’s personality that enabled himto charm his customer into buying. AfterWorld War I, the “Animated Catalog” wasconsidered the right way to sell. Vacuum
  • 116. cleaner salespeople knew all the factsabout their products, and their salespresentations were rehearsed catalogreadings. During the 1930s the slick pitchor “magic formula” was thought to be thebest sales approach. Encyclopedia salesreps would control the presentation andlead the customer down a “mapped-outroad” to a “sure sale.” Many books currentlyon the bookstore shelves claim they holdthe “secret” of how to close a sale. Today,academics agree that personal selling stillrequires some element of pizzazz andcataloglike product knowledge, but salesforces must also have extensive knowledgeof the prospect’s needs and buyingprocesses to be successful. Salespeopleshould sell benefits that solve customers’problems, rather than simply peddlingproducts.
  • 117. Sales Promotion. Sales promotion isdesigned to elicit the desired behavior fromthe consumer, the sales force, and otherchannel participants. Sales promotions aredesigned to complement and reinforceother promotional efforts, especiallyadvertising. Each type of promotion has itsown associated vocabulary that you shouldbe aware of. If you are not a marketer,knowing the vocabulary does not make youan expert, but it can sure help you toengage in intelligent marketingconversation, if need be. There are twotypes of promotions: those directed towardthe consumer, and those directed at thedistribution channels.Consumer sales promotions techniquesavailable are coupons, refund offers,
  • 118. samples, premiums, and contests.Coupons are a direct way to pass a pricereduction on to consumers. As amanufacturer, if you give retailers adiscount in hopes that they will pass italong to consumers, you may be sadlydisappointed. Marketers use coupons toencourage trial, brand switching, and brandloyalty. Grocery coupons are most oftenplaced in a special coupon section of theSunday paper called freestanding inserts(FSI). The leader in FSIs is ValassisInserts, which prints almost half of the $100billion in face value of coupon savingsdistributed annually in Sunday FSIs.Refunds are generally used to acceleratethe normal consumer purchase cycles.Refunds are usually used to increase thequantity or frequency of purchase by
  • 119. encouraging buyers to stock up. Batterymanufacturers frequently use refund offers.Such offers have been cleverly used tostock up consumers just before acompetitor’s promotion or productintroduction.Samples are a high-cost way of introducinga new product. Sampling requires a cashinvestment to produce and stock thesmaller-sized packages. Samples areproperly used for products whose benefitsare “sensory in nature” and cannot becommunicated effectively by advertising.Sampling may also be effective forproducts that consumers would view asrisky in switching to a new brand, or thatmay have a high probability of generatingword of mouth (WOM) activity after use.Many new shampoos use free or low-cost
  • 120. samples since their benefits are sensory.Consumers are reluctant to risk four dollarsto try a whole bottle. Sampling reduces thebuyer’s risk of trial.Premiums are items offered at low or nocost to purchasers of a product. Self-liquidating premiums are those for whichthe price charged covers just costs.Hershey has periodically offered watchesand Christmas ornaments as premiums. Toget the goodies, chocolate lovers have tosend in wrappers as proof of purchase. Mr.Bubble, the happy pink bubble-bath man, ispictured on inexpensive T-shirts, beachtowels, and sweatshirts that are printed onevery box.Contests and sweepstakes are a popularpromotion and the most restricted legally,because they border on gambling. A very
  • 121. thorough analysis of the game rules andthe laws must be conducted to avoid adisaster. State gambling laws must beinvestigated to ensure compliance. Thegame rules and odds of winning must alsobe scrutinized to ensure that thepromotional budget will cover theforecasted costs. In 1984 McDonald’s ran asummer Olympics medal game. Every timethe United States won, game pieces couldbe redeemed for free food and other prizes.When the Communist bloc boycotted thegames, the United States won most of themedals, and most of the game piecesbecame winners.Trade-directed sales promotions toolsinclude sales contests, point-of-purchasedisplays, dealer incentives, trade shows,and in-store demonstrations.
  • 122. There are many variations on the point-of-purchase display (POP). To get them in thestores requires the cooperation of thetrade. On the retail shelf a POP can be ashelf talker, a mini-billboard attached to theend of the shelf with a little ad used toattract attention. Freestanding aisledisplays and built-in shelf displays are otherforms of POP. When a display is at the endof an aisle it is referred to as an end cap.To get those prime spots, the manufacturermust entice the retailer. A marketer can doit by providing a high markup per item or ahigh turnover on lower-margin items.Dealer and employee incentives: Paymentsmade to dealers for marketing support arecalled spiffs. They can take the form ofslotting fees, case discounts, cashpayments, free merchandise, or prizes.
  • 123. Spiffs enable the dealer to discount,promote, or justify carrying a product. Amanufacturer can also give incentives tothe dealer’s employees to place storedisplays or award prizes for meeting salestargets.Trade shows are a way to promote a newor existing product to the wholesalers,dealers, retailers, and distributors. Thispromotion tries to encourage the channelparticipants to carry your product. Afledgling start-up company makinghousewares, for example, would need toattend trade shows to develop thedistribution contacts that might carry theirproducts to retail. If you have no tradecontacts, you have to develop them.In-store demonstrations: Trained expertsfrom the manufacturer are extensively used
  • 124. to promote products that otherwise wouldnot generate consumer interest or beaccepted by the trade. Small kitchengadget hucksters set up demonstrationplatforms to bring inconspicuous blades tolife by creating “beautiful” plate garnisheswith ordinary vegetables. The Cliniqueladies in their white smocks perform asimilar mission for their boxes of “natural”beauty at the cosmetics counter.Whatever the sales promotion you maychoose in a marketing mix, each elementmust have an explicit marketing mission tojustify its cost in the marketing mix.Public Relations and Publicity. Publicrelations (PR) is typically a promotional toolused to communicate to a broaderaudience. PR is intended to create a
  • 125. favorable climate for your product, not todirectly sell it. The list of possible PRtargets can include politicians as well asthe communities in which a companyoperates. The PR message can beintended to create goodwill, correct amistaken impression or factual situation, orto explain a firm’s actions. Sponsorship ofprestigious or charitable events or causesis often used to create a halo effect ofpositive feeling toward a corporation and itsproducts. Hallmark Cards’ sponsorship oftelevision’s Hallmark Hall of Fame aligneditself and its products with the attributes ofquality, culture, and good citizenship.Because the goals of PR are less definedthan a sales target, the results are moredifficult to measure. Opinion polls andlegislative victories are often used to
  • 126. measure PR success.Publicity, a form of public relations, is anyunpaid form of mass media communicationabout a company or product. It can take theform of a news story or even theappearance of a product in the media.Publicity is a two-edged sword. It is judgedas more credible by the public because it isnot purchased; however, there is lesscontrol over the message. Pressconferences, press releases, use bycelebrities, and staged events are used tocapture the media’s attention. Using a PRagency allows you to tap into their mediacontacts to capture an audience andhopefully control the impression madeabout your company or products.When tennis star Pete Sampras or AndreAgassi wears Nike shoes and sportswear
  • 127. at the U.S. Open, the TV can’t help butflash Nike on the screen each time heserves and volleys. This network time hasgreat value. If the athlete makes thenational evening news or Sports Illustrated, which cost $50,000 per thirty seconds and$150,000 per page, respectively, the valueof free media exposure can be great.Accordingly PR executives track theireffectiveness by measuring the value of themedia time or space captured. Trackingservices, such as Burrelle’s press clippingservice for print, report on their clients’ PRand advertising media exposure across thecountry. Burrelle’s can also trackcompetitors in the same way. Although it isoften overlooked in the marketing mix,publicity can often create a tremendousimpact if skillfully and creatively
  • 128. orchestrated.Direct Sales. Direct sales includes therealm of the Internet, junk mail, catalogs,shopping networks, and long-format TVinfomercials. Direct sales are big business.Internet sales exceeded $15 billion in 1999
  • 129. and are growing rapidly. In 1998 mail ordersales alone constituted $465 billion in salesor 6 percent of all retail sales. Over 8,000firms mailed out 12 billion catalogs thatyear and the numbers are still growing. In1999 the leading home shopping network,QVC Network Inc., had over $2 billion insales. Infomercial companies racked upover $400 million in revenues.The nature of the direct mail game is tosegment, segment, segment. Mailers targettheir market with a focused mailing list todirectly reach those households with acompelling mail piece. Lists can bedeveloped internally or purchased fromvendors listed in SRDS’s Direct Mail ListRates and Data directory. The moredefined, affluent, and focused the list is ona desired demographic composition, the
  • 130. higher cost per thousand (CPM) names.The results are tracked by rate of return(ROR) and dollar amount per order.Because TV audiences lack a list’sselectivity, TV sales pitches cannot be asdirectly targeted as direct mail.The other component of both direct mailand TV selling is fulfillment. Fulfillment isthe process of order entry, orderprocessing, inventory management,mailing, and customer service. The dreamsof those viewers of the Home ShoppingNetwork who want to buy porcelainfigurines must be fulfilled. The operationmay be executed internally orsubcontracted out to a fulfillment house thatperforms the duty for a per-order fee overcertain volume minimums. It saves smallercompanies the initial investment required to
  • 131. establish in-house fulfillment capabilities.Because direct selling is becoming such alarge part of the economy, it should not beignored as a possible channel to theconsumer. A thorny issue connected withthis selling method is the backlash againstthe “big brother” effect of having verypersonal information captured in mailinglists that churn out personalized pitches.This topic, like slotting fees, is a “hot” onefor MBA chatter.Each method of promotion—advertising,personal selling, sales promotions, publicrelations, and direct selling—canaccomplish a separate mission dependingon the product, the place of sale, and theprice. The gifted marketer goes to his orher palette of promotional options andcombines them in a coordinated
  • 132. promotional strategy to sell the productefficiently.Product Place PromotionPricePricing Decisions: What Should My PriceBe?The pricing decision, like the productdecisions, can dramatically affect themarketing mix by suggesting a channel ofdistribution or an advertising strategy. Thepricing itself can differentiate your productfrom the competition. Both the Yugo andthe Rolls-Royce are differentiated atopposite ends of the automobile spectrum.There are many rationales behind pricingeach product and service. Haven’t youseen a pair of Nike cross-trainers for sale at$59.95 instead of $60 for somepsychological advantage? Besides
  • 133. psychological pricing, there are eight majorpricing methods and strategies suggestedby research and case analyses.Cost Plus. This is a simple method oftaking your cost and adding a desired profitmargin. Highway contractors often use thissimple method; however, it is not theproper way to price.Perceived Value to the Consumer. You cancharge the customer the value provided,regardless of its cost. Replacement partsare a prime example—exorbitant prices arecharged for a cheap but crucial custom nutor bolt. The owner of a fixture manufacturerconfided to a group of my classmatesduring a school-sponsored plant visit thatthe majority of his company’s profits were
  • 134. derived from the twenty-by-twenty-footreplacement-parts cage, not from the longassembly lines producing the fixtures. If theprice charged for an item is commensuratewith the benefits provided, then it will beconsidered a good value in the mind of thebuyer. But remember, there are limits evenin a monopolistic situation.Skimming. Early in the introduction phaseof the PLC, a company can opt to charge ahigh price and skim high margins from anew and novel product or service. Themargins could be used to further R&D, as isdone in high-tech industries, or toimmediately reward the owners for fadproduct introductions. RCA used thisstrategy to charge high prices for color TVswhen they were introduced in the 1960s.
  • 135. Penetration. This pricing can be used in theintroductory phase or later in the PLC. Apenetration strategy would use a low priceto gain market share; the goal is primarilyto lower costs per unit by producing manyunits in hopes of eventually controlling amarket as the low-cost producer. Thespecifics of this strategy are discussed laterin the Strategy chapter’s discussion ofJapanese VCR production.The Price/Quality Relationship. Becauseconsumer perceptions are not necessarilybased on just the physical attributes of aproduct, the “perceived” quality is ofteninfluenced by its price. Apparel, perfume,and jewelry are examples where the priceitself affects the perception of product
  • 136. attributes. Consumers often attribute thecharacteristics of style and workmanship toa product just because of the high pricecharged.Meet Competition. Strategies frequentlydecide to match or beat competitors’ pricesto gain or retain market share in acompetitive market. This is especially thecase in commodity products and servicessuch as gasoline, steel, and airline tickets.The economics of pushing a productthrough the distribution chain, as explainedin the discussion of distribution channels,has a great effect on what price amanufacturer can charge to sell his productto the distribution chain and still end up witha competitive retail price.
  • 137. Meet Profit Goals Based on the Size of theMarket. If a market is limited in size, then aprice must be charged that will allowenough profit to justify the marketing andmanufacturing effort. If the product cannotcommand a profitable price, then to lowercosts investigate either other user marketsor manufacturing improvements.Price Based on the Price Elasticity of theBuyer. Price elasticity describes how abuyer’s behavior changes due to a changein price. Buyers with elastic demand do notreadily accept price hikes. Their demand isgreater or smaller depending on the price.Buyers with inelastic demand behaviorsdon’t care about price increases. Theydon’t decrease their quantity or frequency
  • 138. of purchase depending on the price.Tobacco and crack cocaine smokers, forexample, have absorbed many priceincreases and continue to buy becausetheir addiction makes their demandinelastic to pressure to accept priceincreases. If elastic, buyers will not paymore than a given price point and will stopbuying or buy much less based on theintensity of their desires, their personaldisposable income, or their psychologicalprice thresholds. Former New York Citymayor Edward Koch proposed in the 1980sthat the bridge tolls onto Manhattan Islandbe raised to ten dollars to reduce the city’sgridlock traffic conditions. He believed thatthe majority of the driving public’s demandwould be elastic to such a price increase.
  • 139. There are many avenues that may be takenwith any given product. In the case of mygourmet packaged coffee, a distinctivecoffee “product” may require a distinctivepackage, a higher “price,” a targetedpromotion, and a selective “place” fordistribution. But what really tells the story isthe economics. Can I do it and makemoney?6. What Are the Economics of My Plan?Consumer Market CompetitionDistribution Marketing Mix Determine theEconomics ReviseThis may be the last step of marketinganalysis. This step may also send themarketing manager directly back to Gowithout collecting two hundred dollars. Bythat I mean that the consumer analysis maybe exemplary, the marketing mix masterful,
  • 140. but it just doesn’t make money. The costsmay be too high, the market price too low.Perhaps unrealistically high sales volumemay be needed to break even. In those sadcases the entire circular process ofmarketing strategy must be restarted in aneffort to find a profitable solution. Todetermine whether you have created a planthat is both profitable and reasonable youmust address several issues.What are the costs?What is the break even?How long is the payback of my investment?What are my costs? Fixed or variable?The first cost question for a marketingmanager should be, “Which of my costs arevariable and which are fixed?” If this
  • 141. sounds like accounting, it is.Variable costs are those that vary with thevolume of products sold or manufactured.The costs of materials and labor arevariable costs. As more units are sold ormanufactured, the total costs of materialand labor are higher. Fixed costs do notvary with volume even if no sales aremade. As volume fluctuates neither rent norsupervisor salaries change—within arelevant range. By that I mean that if salestriple, a new factory may have to be leased,and thus fixed costs will go up. Promotionalexpenses such as advertising are alsoseen as a fixed cost of a marketing plan,because if the product is a flop theadvertising dollars are already spent. Theyare considered sunk costs—after a TV adairs, the dollars are “sunk” in the ocean of
  • 142. TV land. Total costs are a combination ofboth variable and fixed costs.Total Costs = Variable Costs Per Unit (VC)× Units Sold + Fixed Costs (FC)They can also be shown graphically asfollows:Wooden End Table Production
  • 143. Fixed Costs + Variable Costs = Total Costs
  • 144. What can be seen in the graphs is thatregardless of unit volume, the fixed costsremain constant. When units are actuallyproduced, variable costs are added on topof the fixed costs to equal total costs.What is my break even and is itreasonable?Break even is the point at which the fixedcosts are recovered from the sale of goodsbut no profit is made. Promotion andmanufacturing are very expensive. A waymust be found to recoup thoseinvestments. That’s the whole point ofmarketing: to recover costs and makeprofits.
  • 145. (Unit Contribution = Your Selling PriceVariable Costs)Using my data from the coffee industry, Ihave provided an example from the realworld. I determined that the prices andcosts of a proposed marketing plan for theMexican gourmet coffee were:CostCost Type Retail Sales Price $6.00 lb.Selling Price to Distributors 4.20 lb. CoffeeBeans Cost 1.00 lb. Variable Roasting andProcessing Cost .44 lb Variable PackagingCost .55 lb. Variable Shipping Cost .25 lb.Variable Spiffs and Slotting Fees 50,000Fixed Production Equipment Rental 12,000Fixed Promotional Efforts 150,000 Fixed
  • 146. The corresponding break-even volume wascalculated:And the break-even dollar sales were:108,163 lbs. × $6.00 lb. = $648,978 break-even retail salesThe same equation can be used tocalculate a target volume to yield a desiredprofit.
  • 147. To return a $30,000 profit target, you justadd the profit to the numerator with thefixed costs.One very important aspect of this analysisis that it does not include the costs thatwere “sunk” in the development of theproduct or the ad campaign if they havealready been spent. The evaluation of theeconomics is always performed from theperspective of the present. There shouldnot be any crying over spilled milk. Youneed to decide if you can make money on
  • 148. the proposed marketing spending in thefuture. For example, if the coffee blend wasthe product of millions of dollars ofresearch, that would be irrelevant to thedecision to whether I should spendadditional money to market it. If I includethe millions of research, it would be adefinite “no go.” However, with that moneydown the drain, it might be profitable toinvest additional cash in a marketing effort.The graphical representation of themarketing plan economics for the Mexicancoffee looked like this:Gourmet Coffee Marketing Plan Economics
  • 149. Is my break even reasonable in relation tomy relevant market? Answering thisquestion must be your next step. In thecoffee example, $648,978 of break-evenretail sales was a .26 percent share of the$248 million market for gourmet,nonflavored coffee sold through thesupermarket channel as explained earlier in
  • 150. the chapter. The targeted retail sales of$740,814 equaled only a .3 percent shareof the relevant market. On that level, theplan appeared reasonable if I believed$150,000 of promotion and $50,000 ofdealer incentives could have produced$740,814 in sales. Imagine that—I couldhave reached my goal with only a .3percent share of the market!Unfortunately, a small target share caneasily lead you to believe that it is easy toobtain. How fierce was the fight for thegrocers’ shelf? If my coffee got on the shelf,somebody else’s had to be kicked off. Howwould they react? Once in the supermarket,would my company have been willing tocontinue to support the coffee when acompetitor went after my shelf space? Inmy case, the company was not willing yet
  • 151. to make that kind of long-term commitmentto coffee.What is the payback period on myinvestment?This is another hurdle frequently used bycompanies to evaluate marketing projectswhen they have many to choose from.Companies want to know how long it willtake just to get their investment back.Forget about profit. The payback formula is:In the coffee example, the calculationwould be:
  • 152. If the yearly profit is not the same eachyear, there is no formula. The break-evenpoint is where the plan returns the initialinvestment.Seven years is a bit long for a riskyventure. This may indicate that the wholemarketing development process shouldstart again. And unfortunately for me it did.7. Go Back and Revise the PlanConsumer Market CompetitionDistribution Marketing Mix EconomicsRevise the PlanAt this stage of disappointment, I revisitedthe marketing strategy developmentprocess outlined at the beginning of thischapter. In circumstances such as those Ifaced, you must either tweak or discardyour plans entirely. You may have
  • 153. something that can be salvaged…if you’relucky. You have to start by asking yourselftough questions. In the case of the coffeeproject I tormented myself with:Should I target another segment?Is the mail order distribution channel anoption?Should I not advertise and rely on a cheapprice to move my product?As these questions indicate, the marketingprocess is not easily defined or executed. Itcan be frustrating because there are no“right” answers. Consumer reactionscannot be easily predicted. It takescreativity, experience, skill, and intuition todevelop a plan that makes sense and
  • 154. works together (internally consistent andmutually supportive). Marketing alsorequires close attention to the numbers tobe successful. With this chapter you arearmed with the MBA problem-solvingstructure and the MBA vocabulary to attackthe marketing challenges that you mayencounter. You haven’t even paid a dollarin tuition, sat through a class, or anted upfor an expensive executive seminar. Figurethe break even on that investment!I include the following notes that we allpassed among ourselves at school to guideour case discussions and tests (opennotes). These are the key questions thatmust be addressed by a comprehensivemarketing strategy.
  • 155. Marketing Strategy Outline1.Consumer Analysis- Makable or marketable product?- Who’s buying, who’s using?- What is the buying process?- Who are the “Influencers”?- How important is it to the consumer?- Who needs it and why?- What is the value to the end user?- Is it a planned or impulse buy?- What are the perceptions of our product?- Does it meet their needs?
  • 156. Market Analysis- What is the market’s nature? Size, growth, segments, geography, PLC- Competitive factors? Quality, price, advertising, R&D, service- What are the trends?Competitive Analysis- What is your company good at? Poor at?- What is your position in the market? Size, share, reputation, historical performance- What are your resources? Trade relations, sales force, cash, technology, patents,
  • 157. R&D- Who is gaining or losing share?- What do they do well?- Compare your resources to theirs.- What are the barriers to entry?- What are your objectives and strategy?- Any contingency plans?- Short-and long-term plans and goals?Marketing Mix- Who is the target?- Product—Fit with other products? Differentiation, PLC, perception, packaging,
  • 158. features- Place—How best to reach segment, channel mathematics, draw channels.- Exclusive, selective, intensive distribution? Fit with product?- Who has the power?- How to motivate the channels?- Promotion—What is the buying process? How are $’s targeted to buying-process goals?- Push or pull strategy?- Media—type, measure, message
  • 159. - Dealer incentives- Consumer promos—coupons, contests- Price—What strategy? Skim, penetrate?- Seek volume or profits?- Perceived value, cost-plus pricing?- How does price relate to the market, size, product life cycle, competition?Evaluate the Economics- Break even in units- Fixed Cost/(Selling—Variable Cost) Include fixed marketing and promo costs in fixed costs of the plan!
  • 160. - Relate break even to relevant market- What is the payback period? Exclude sunk costs!- Are goals reasonable? attainable? Key Marketing TakeawaysThe 7 Steps of Market StrategyDevelopment:1.Consumer analysis2.Market analysis3.Competitive analysis4.Distribution channel analysis5.Develop the marketing mix6.Determine the economics7.ReviseNeed Categories—All the possible uses ofa product or service
  • 161. The Buying Process—The stages ofmaking a purchaseProduct Involvement—The importance of aproduct to the consumerSegmentation Variables—Ways to dividethe population to find a profitable targetRelevant Market—The portion of themarket that is interested in your productProduct Life Cycle—The birth-to-death (andpossibly rebirth) life cycle of a productPerceptual Mapping—A multivariablepicture of a product and its competitorsChannel Margin Mathematics—Each levelin the distribution takes a margin of theselling price it charges to the next level ofdistribution.The Marketing Mix of the 4 P’s—Product,place, promotion, and price
  • 162. Distribution Strategies—Exclusive,selective, and mass marketChannel Power—Who in the distributionchain dictates the terms of the relationshipsAdvertising Measures—Reach, frequency,GRP, TRP, share of voice. Buy wisely.Pricing Strategies—Cost plus, penetration,value pricing, skimmingBreak Evens—The volume of sales neededto recover the fixed cost of marketing plan Day 2 Ethics Ethics Topics
  • 163. RelativismStakeholder AnalysisUnlike most topics in the MBA curriculum,which have remained fairly consistent fordecades, ethics is a new area in the MBAprogram. What appeared at first to be onlya trendy elective course has now becomeinstitutionalized as part of the core MBAcurriculum at Harvard, Wharton, andDarden. With the criminal convictions ofinsider traders in the 1980s, businessschools took notice and jumped on theethics bandwagon in the 1990s.Ethical dilemmas make for a livelyclassroom discussion. It was revealing tosee my fellow students deal withcontroversial topics. My “politically astute”classmates would play it safe and take the
  • 164. ethical high ground before teachers andpeers. My more insecure classmates wouldnot participate at all. Others would expressjust what they thought, no matter howpolitically “incorrect” it may have sounded. Ifell into this last group. But I must admit, Itook many unpopular positions just to livenup the class discussion. In any case, ethicsis a good topic for speaker forums andgreat fodder for articles and dissertations.Since ethical problems often have nodefinitive answers, the area will remainfertile academic ground for years to come.The purpose of ethics in the MBAcurriculum is not to make students modelcorporate citizens. Rather, the intention isto make students aware of the ethicalimplications of business decisions. Throughcasework and role playing, students
  • 165. confront ethical dilemmas similar to thosethey will face in the workplace.The top business schools train their futurechampions of industry to deal with anychallenge. You name the “hot” topic, wethrashed the issue out in class:
  • 166. Environmental issues—pollution, toxicwaste dumping, animal rightsCorporate restructuring—layoffsEmployee privacy issues—AIDS, drugtesting“Diversity” issues—race, ethnicity, gender,and sexual orientationSexual harassmentConduct of multinational corporations(MNCs)—briberyOther—antitrust actions, predatory pricing,insider trading The Social Responsibility of Business
  • 167. Talk about ethics rests on the assumptionthat businesses ought to adhere to asocially responsible approach to decisionmaking called the social responsibilityapproach. Proponents of this approachbelieve that corporations have societalobligations that go beyond maximizingprofits. Business schools encouragestudents to adopt this “politically correct”philosophy. It is argued that becausecorporations are so powerful, they have anobligation to assume social responsibilities.Corporations should be managed for thebenefit of their stakeholders: theircustomers, suppliers, employees, and localcommunities, as well as their owners.Corporate leaders bear a fiduciaryresponsibility to all stakeholders.
  • 168. Flying in the face of the “politically correct”philosophy espoused at most institutions isa competing school of thought led by MiltonFriedman of the University of Chicago.Friedman believes that business’s sole dutyis to make profits. “Businesses are in thebusiness of maximizing shareholders’ valueby a prudent use of scarce organizationalresources, as long as the activities of thebusiness are within the letter of the law.” InFriedman’s view, it is up to government todetermine what the laws should be. Aprofitable business benefits society bycreating jobs, increasing the standard ofliving of its owners and its employees.Corporations pay the taxes that supportgovernment’s social action. AlthoughFriedman is exalted as one of thedefenders of capitalism in economicscourses, my school tended to discourage
  • 169. his views when it came to ethics class.There are two major topics taught in theethics curriculum: relativism andstakeholder analysis. Relativism examineswhy we often ignore ethics in our decisionmaking, while stakeholder analysisprovides a structure with which to confrontethical decisions. RelativismThe proponents of relativism hold that wecan’t decide on matters of right and wrong,or good and evil. Things are rarely black orwhite. There are so many shades of gray.Relativism proposes that ethics are“relative” to the personal, social, andcultural circumstance in which one findsoneself. Relativists are not torn by ethicaldilemmas since they do not believe thattruth can be discovered through soul
  • 170. searching. Professors teach relativism sothat students may guard against it. Tounderstand relativism, you need torecognize its four forms:Naïve RelativismRole RelativismSocial Group RelativismCultural RelativismNaïve relativism holds that every personhas his or her own standard that enableshim or her to make choices. No one canmake a moral judgment about anotherperson’s behavior. So many variablesaffect behavior that an outsider cannotpossibly be privy to all the elements thatwent into making a decision. Therefore, an
  • 171. executive at Borden is not equipped tomake a moral judgment regarding theactions of the chief executive officer (CEO)of Nestlé, whose corporation is possiblyselling harmful baby formula in developingcountries.Role relativism distinguishes between ourprivate selves and our public roles. Thesepublic roles call for a “special” moralitywhich we separate from the individualmaking the choices. The president of afishing company may personally dislike theincidental killing of dolphins in hiscompany’s tuna nets, but as an executive,he must not let his feelings interfere withthe best interests of the company.Social relativism is akin to naïve relativism.People refer to social norms to renderethical judgments. “Industry practices,”
  • 172. “club rules,” “professional codes ofconduct,” and “accepted practices” are thecop-outs of the social relativist. In theproduce industry, it is “industry practice” toignore child labor laws and employ smallchildren to work in the field and missschool.Cultural relativism holds that there is nouniversal moral code by which to judgeanother society’s moral and ethicalstandards. If a whole culture holds certainbeliefs, how can an outsider sit injudgment? “When in Rome…” The conceptof cultural relativism becomes moreimportant as companies compete globally.Multinational corporations often follow locallaws and customs that may violate ethicalstandards in their home countries.Discussions about apartheid revolve
  • 173. around issues of cultural relativism.Adopting a cultural relativist philosophy, amultinational corporation might havejustified its participation in South Africangold and diamond mining activities despitethe employment of “slave” labor in themines.In some instances U.S. corporations andcitizens are barred from adopting the hostcountry’s business practices. In somecountries it is ordinary business practice topay bribes to get favorable treatment frombusinesses and government. The ForeignCorrupt Practices Act of 1977 outlawsoverseas bribery.The relativism concepts provide MBAs withan awareness of and a way to guardagainst inaction on ethical and moralissues. They provide a framework to go
  • 174. beyond currently held beliefs and patternsof behaviors. These concepts are alsogreat conversational ammunition whenMBAs get together on social occasions.Other Ethical Frameworks. Relativism isnot the only philosophical framework withwhich to approach ethical decisions. Thereis also natural law, utilitarianism, anduniversalism. Natural law serves as a guideto some who believe that the “right” thing todo is revealed in nature or the Bible.Utilitarianism holds that an action is justifiedif it provides the greatest benefit for thegreatest number of people. Finally,universalism propounds that any action iscondonable if the motive behind the actionis good, since the results of a person’sactions are so often not in his or hercontrol.
  • 175. Stakeholder AnalysisAlthough there are no magic formulas forsolving ethical dilemmas, it is helpful tohave a framework with which to organizeyour thoughts. Stakeholder analysisprovides you with the tools for weighingvarious elements and reaching a decision.As a first step a list should be made of allpotentially affected parties, then anevaluation of all the harms and benefits thata particular action will have on thoseinvolved. The next level of analysis ought todetermine each of the affected parties’rights and responsibilities. Employees, forinstance, have the right to a fair wage andsafe working conditions, but they also havethe responsibility to be productive for thecompany. In a typical stakeholder analysisthe list of potentially affected parties might
  • 176. look like this:The Decision MakerExecutives, board of directorsCustomers—and the industry in which theyoperateShareholders, bondholdersSuppliers—and their industryEmployees—and their familiesGovernment—federal, state, and local andtheir agenciesSpecial Interest Groups—industrial,consumer, environmental, political, unionsThe Affected CommunityThe Environment—plants, animals, naturalresources
  • 177. Future Generations (an MBA favorite)CompetitorsLawyers and the CourtsObviously, the list could be much longer. Atthe analysis stage the list is narrowed tothe significant players, then a situationalanalysis is performed, and eventually adecision is reached. In order, these are thesteps:1.Get the main cast of characters.2.Determine the harms and benefits to each player.3.Determine their rights and responsibilities.4.Consider the relative power of each.5.Consider the short- and long-term consequences of your decision
  • 178. alternatives.6.Formulate contingency plans for alternate scenarios.7.Make a judgment.If you are interested in walking through thesteps outlined above, take out a recentcopy of Time or Newsweek and pick a topicwith an ethical aspect. With a piece ofpaper, jot down the main characters alongthe top, then along the side, place thewords “Harms and Benefits” first, andbelow that “Rights and Responsibilities.”Now you have the framework with which toattack the moral dilemmas of theday—MBA style.As an example, you might choose thedebate regarding the need to preserve thehabitat of the spotted owl by reducinglogging on federal lands. The stakeholder
  • 179. analysis grid would look like this:Spotted Owl Issue in a StakeholderFramework
  • 180. You may disagree with the way in which Ihave framed this issue, but with ethicsthere is no “right” way. People canapproach a situation differently and feelother stakeholders need to be represented.In this situation, at the very least, a timberCompany executive ought to consider thestakeholder before clear-cutting the owl’swoods. With the tools of stakeholderanalysis an MBA can tackle the issue ofendangered owls as well as other ethicalissues and make thoughtful and informeddecisions. Key Ethics TakeawaysSocial Responsibility of Business—Concept that businesses are accountableto more than their ownersRelativism and Its Four Forms—Reasonsto avoid making ethical decisions
  • 181. Stakeholder Analysis—A frameworkconsidering who is affected by a businessdecision Day 3 Accounting Accounting TopicsAccounting RulesAccounting ConceptsThe Financial StatementsRatio AnalysisManagerial AccountingAccounting is the language of business.Corporations need to communicate theirresults to the world. Their audience
  • 182. includes employees, investors, creditors,customers, suppliers, and communities.Within the company, accountinginformation provides a means to control,evaluate, and plan operations. Whateverthe audience or function, accounting isnumbers. Accountants (account-ants)“count the beans” so that business activitycan be recorded, summarized, andanalyzed. Accountants have been aroundfrom the beginning of time and professorsdon’t let you forget it.In biblical times the accountants kept trackof how much grain was stored in thecommunity’s silos. How do you think KingSolomon knew that there was only a thirty-day supply of grain during a drought? Itwas from the accountants. Throughout theages accountants have kept track with their
  • 183. fingers, abacuses, and calculators. Inmodern times accounting has gone beyondthe physical count of grain in storage.Accounting answers these basic questionsabout a business:
  • 184. What does a company own?How much does a company owe others?How well did a company’s operationsperform?How does the company get the cash tofund itself?All corporate activities must eventually bemeasured in dollars, and that is whereaccounting comes in, like it or not. Althoughthis area may appear tedious, you musthave a working knowledge of accounting tofunction in the business world. Becauseknowledge is power, MBAs need to beliterate in accounting to understand itsfunction; more important, they must be ableto ask for and use accounting informationfor decision-making purposes. Lawyers
  • 185. with accounting knowledge, for example,can interpret financial statements to getvaluable information. In settlementnegotiations, they become a force to bereckoned with. Because employeeperformance is often evaluated withaccounting data, a knowledge ofaccounting is essential.Having expert knowledge of complexaccounting rules, however, is not theMBA’s goal. Therefore, my aim here is togive you the basics, not to make you aCPA. Because every function of business,including finance, operations, andmarketing, uses the numbers generated bythe accountants, it is very important tograsp the fundamentals and read thischapter carefully.
  • 186. Gaap RulesAccounting has innumerable rules. Youshould not attempt to memorize them, butyou should become sufficiently familiar withthem to communicate with CPAs.Accounting rules set the standards so thatfinancial reports of companies may becompared on an equal basis. Accounting’sgoverning rules are called GenerallyAccepted Accounting Principles (GAAP).These “Gap” rules have been developedover the years and are analogous to theprecedents in the legal profession.As new areas of business activity develop,the Financial Accounting Standards Board(FASB) writes additional rules to deal withthese situations. This body has generatedover a hundred “Fasbee” rules over theyears and accountants refer to them by
  • 187. number. For example, FASB 90 was issuedin 1987 because of the problems of faultynuclear plant construction. Electric utilities,such as WPPSS (“Whoops”) in theNorthwest, needed guidance on how toaccount for the abandonment of billions ofdollars of unsafe and unnecessary plantfacilities.The Fundamental Concepts of AccountingTo understand accounting, before you getinto the numbers you first must becomefamiliar with the underlying concepts. Therules do not tell the whole story. Thefollowing seven concepts and vocabularyare not a set of laws, but rather a guidingset of policies that underlie all accountingrules and reporting.
  • 188. The EntityCash and Accrual AccountingObjectivityConservatismGoing ConcernConsistencyMaterialityThe EntityAccounting reports communicate theactivities of a specific entity. Theparameters covered by an accountant’sreport must be clear. A reporting entity canbe a single grocery store, a productionplant, an entire business, or aconglomerate. For example, General Millsprepared reports for each of its Red
  • 189. Lobster restaurants. It also reported on theentire chain of Red Lobster restaurants, aswell as its restaurant group, which alsoincludes the Olive Garden chain. Of course,there is an overall report for the wholecorporation which includes Cheerios, BettyCrocker, Gold Medal flour, and Yoplaityogurt. In 1995, General Mills spun off itsrestaurants into a separate company,Darden Restaurants. The operations werealready segregated and ready to becometheir own independent entity.Cash Basis Versus Accrual AccountingHow the beans are being counted is veryimportant. Using cash basis accounting,transactions are recorded only when cashchanges hands. Very small businesses canget all the accounting information they needfrom their checking account register. If a
  • 190. store pays two years’ rent in 2000, all therent cost would be recorded as a cost in2000, not over a period of two years. Whena small machine shop purchases a powertool, its cost would be recorded when it waspurchased, not over the useful life of thetool. Get the idea? Cash accounting tellsyou when and how much cash changedhands, but it doesn’t try to match the costsof conducting business with their relatedsales.Most companies of any significant size usethe accrual accounting method. Accrualaccounting recognizes the financial effectof an activity when the activity takes placewithout regard to the movement of cash.Kmart’s rental costs are recorded eachmonth with the benefits of occupancy. Thecost of rivet guns at Boeing’s aircraft
  • 191. factory is recorded over the useful life ofthe tools as workers use them on thefactory floor. Due to the dollar magnitude ofBoeing’s purchases, cash accountingwould distort its financial statements.Accrual accounting, as a consequence,raises two related issues, allocation andmatching, because activity and cashmovement most often do not occur at thesame time.Allocations to Accounting Periods. Becauseprofit and loss statements reflect activitiesover a specific period of time, the period ofrecognition is very important. If IBM sold alarge computer on credit to Ford MotorCompany on December 31, 2000, accrualaccounting would record the sale in 2000when the binding contract was signed, not
  • 192. when Ford actually laid out the cash in2001. The sale could be recorded at thatpoint, because it was then that Fordbecame legally bound to take delivery ofthe computer. That was also the period inwhich IBM’s accounting records wouldrecognize the sale and its related costs andthe profits. Ford, on the other hand, wouldrecognize or accrue and allocate the cost ofusing the computer over its useful life.Matching. Using the same logic as inallocation, sales made in one period arematched with their related selling costs orcost of goods sold (COGS) in the sameaccounting period. By matching salesdollars with their related costs, you canfigure the profit a company has actuallymade. For example, when Safeway sells
  • 193. fresh produce on December 31, 2000, butdoesn’t pay the supplier’s bill until 2001,accrual accounting will nevertheless recordthe costs related to those sales in 2000.Safeway’s sales in 2000 caused theexpense, and therefore, the sales shouldhave the related costs allocated againstthem in the same year. Without establishedpolicies for allocation and matching,accountants could easily manipulatefinancial reports by choosing when torecord sales or expenses in order to coverup or delay bad results.Transaction Definition and ObjectivityAccounting records only containtransactions that have been “completed”and that have a “quantifiable” monetaryvalue. Sales that have not been completed,but are thought of as “sure things,” cannot
  • 194. be recorded. Even if a trustworthysalesman from Navistar (formerlyInternational Harvester) swears that farmerJones is a sure bet to buy a combine, theaccountant would say no. For hisaccounting purposes, the sale has nottaken place. Navistar has not delivered themachinery, nor has the farmer signed anenforceable contract.Accountants also have an objectivity rule toguide them when in doubt. There must bereasonable and verifiable evidence tosupport the transaction, or else it does notget recorded.For example, the goodwill generated by apublic service campaign cannot berecorded on the books. What value couldyou put on it? Archer Daniels Midland(ADM) regularly runs TV propaganda telling
  • 195. consumers how cheap food is in Americacompared with the rest of the world. Howcould an accountant objectively put a dollarvalue on the “good feelings” directedtoward the company in the hearts ofgrateful Americans or incumbentcongressmen? Patents and inventions arealso hard to value. If Du Pont purchases apatent on a new chemical from an inventorfor $1,000,000, it would be recorded on thebooks at $1,000,000. The patent hasquantifiable market value. However, if a DuPont scientist developed a new process inthe lab, the accountants could not recordthe innovation until it was sold. Theaccountant would need to have a contractand a canceled check to substantiate theentry in the books.
  • 196. Accounting Conservatism and HistoricalCostsWhen companies incur losses that areprobable and that can reasonably beestimated, accountants record them, evenif the losses have not actually beenrealized. When gains are expected,accountants postpone recording them untilthey actually are realized. If in 1986 themanagement of International PaperCompany anticipated a big profit in 1988 onthe sale of their Manhattan corporateheadquarters, they could not record theirprofit until 1988. Their move to Memphiswas uncertain. Management could havechanged their minds, or the real estatemarket could have tumbled. But for thesake of argument, let’s assume thatInternational Paper discovered in 1986 that
  • 197. in 1988 it would have to clean a toxic-wastepool beneath its building. Managementwould have to hire a consultant to estimatethe cost of cleanup and record that cost in1986. In this way, the financial statementreaders would be warned of dark cloudslooming over the horizon in 1988.Accounting conservatism governs thepreparation of financial statements. Whenin doubt, be conservative. Accountingrecords contain only measurable andverifiable properties, debts, sales, andcosts.Conservatism also dictates thattransactions be recorded at their historicalcosts. International Paper’s New Yorkheadquarters appreciated in value duringthe real estate boom of the 1980s, and yetthis gain could not be recognized, even if
  • 198. the company had paid the Indians a fewtrinkets for it in the 1600s. The recordscontinue to value the real estate at the costof the beads given to Indians in exchangefor the property. In the accountant’s mind,the value of the building may decline by thetime it’s sold.If the value of an asset falls below therecorded cost, that’s another story.Conservatism dictates that the loss berecognized today. To do otherwise couldmislead the reader of a financial statementto believe that the assets represented areat least worth their historical cost.The value of goods held in inventory is alsostated at historical cost. Even if priceschange, the objective price is that which thebusiness paid historically. There must beverifiable purchase orders and bills to
  • 199. support the cost. For instance, if Ginn’sOffice Supplies carries notepaper producedby International Paper on its books, it wouldvalue the paper at cost. Even if reordercosts for the same inventory had gone up,the cost of the merchandise on hand wouldremain at Ginn’s historical cost on thebooks.Going ConcernFinancial statements describe businessesas operating entities. The values assignedto items in the accounting records assumethat the business is a going concern.Accountants presume that companies willcontinue to operate in the foreseeablefuture, therefore, the values assigned in thefinancial statements are not “fire sale”prices. They use historical costs, as youalready know. Steel rolling equipment, for
  • 200. example, is expensive to purchase. It mayhave great value to an ongoingmanufacturing company such as US Steel,but put up for sale at a bankruptcy auction,its value would be pennies on the dollar.Used industrial equipment has limitedvalue to outsiders. Accordingly, accountingrecords use historical costs assuming thatthe company is using its machineryproductively.ConsistencyThe consistency concept is crucial toreaders of financial statements. Accountingrules demand that an entity use the sameaccounting rules year after year. Thatenables an analyst to compare past withcurrent results. This rule, like the otherspresented earlier, tries to minimize thetemptations of accounting monkey
  • 201. business that businessmen like to engagein to cover up bad results.The consistency rule insists that companiesvalue their inventory the same way fromyear to year. The major methods availableare a FIFO (First In First Out) or LIFO (LastIn First Out) basis. Using FIFO, the oldestpurchase costs of goods are recognized ascosts “first,” leaving the most recentlypurchased cost of goods in the value ofinventory held for sale. Using LIFO, the“last” costs of goods are recognized ascosts first, leaving the oldest costs in thevalue of inventory. The accounting methodis independent of the physical movement ofinventory. It is just an accounting method.As you might imagine, if you could changeaccounting methods at will, a craftyaccountant could manipulate the financial
  • 202. statements from year to year. Consistencyrequires that the same accounting methodbe used from year to year.As an example of FIFO and LIFO methods,consider a coin dealer who has only twoidentical gold coins in his showcase. Onehe bought in 1965 for $50, and the other hepurchased in 2000 for $500. A numismatistcomes to his shop and buys one of thecoins for $1,000. Using FIFO, the shopowner would record a sale of $1,000, a costof $50, and a resulting profit of $950 in hisaccounting records. His remaininginventory would reflect one coin at ahistorical cost of $500. The cost of the firstcoin purchased was the first to be recordedas a cost of goods sold. Using the alternateLIFO method, the owner would record acost of $500, and a profit of only $500. His
  • 203. inventory records would show a coin with avalue of $50. The last cost was used first.Which coin was actually sold, the 1965 orthe 2000 acquisition, does not matter. It’sonly an accounting method. But the methodchosen dramatically affects the way acompany calculates profits and valuesinventory. That does matter.If a change of accounting method isnecessary for a “substantial” reason, thefinancial statements must state the reasonin the Footnotes located at the end of thereport. The footnotes must state thechange and its justification. The footnotemust also state how the change affectedthe profits and asset values that year. Youcan run, but you cannot hide from theaccountants.
  • 204. MaterialityAn important caveat of financial statementsis that they are not exact to the penny,even though you would expect thattenacious accountants would produce suchreports. In fact, they are only materiallycorrect so that a reader can get a fairlystated view of where an entity stands.Financial statements give a materiallyaccurate picture so that a reasonableperson can make informed decisions basedon the report. For a small soda fountain’sfinancial statements, a one-hundred-dollarerror may materially distort the records,while a ten-dollar error may not. In contrast,huge multinational companies like Coca-Cola may have million-dollar errors in theirreports and not materially distort the picturefor decision making.
  • 205. By now you can begin to develop an insightinto how accountants think aboutbusinesses and possibly why they are, forthe most part, conservative even as people.I found the cartoon on page 72 on thebulletin board at Arthur Andersen LLP, oneof the Big Five international accountingfirms, where I worked as a CPA for threeyears and had conservativism burnt into mypsyche. I still wear white button-downcollared shirts out of habit. The Financial StatementsMBAs are not trained to key transactionsinto a computer; rather they are schooled tointerpret the information that accountantsgenerate. The financial statements are thesummary of all the individual transactionsrecorded during a period of time. Financial
  • 206. statements are the final product of theaccounting function. They give interestedusers the opportunity to see what went onin a neat summary. To know a company,you must be able to read and understandthree major financial statements:
  • 207. The Balance SheetThe Income StatementThe Statement of Cash FlowsThe Balance SheetDefinitionsTo set the stage you need to know thebasic vocabulary of the balance sheet. Thebalance sheet presents the assets ownedby a company, the liabilities owed to others,and the accumulated investment of itsowners. The balance sheet shows thesebalances as of a specific date. It is asnapshot of a company’s holdings at agiven point in time. The balance sheet isthe foundation for all accounting records,and you must be familiar with it. Thefollowing are the components of balancesheets.
  • 208. Assets are the resources that the companypossesses for the future benefit of thebusiness.- Cash- Inventory- Customers receivables—accounts receivable- Equipment- BuildingsLiabilities are dollar-specific obligations torepay borrowing, debts, and otherobligations to provide goods or services toothers.- Bank debt- Amounts owed to suppliers—accounts payable- Prepaid accounts or advances from customers to deliver goods and services
  • 209. - Taxes owed- Wages owed to employeesOwners’ equity is the accumulated dollarmeasure of the owners’ investment in thecompany. Their investment can be either inthe form of cash, other assets, or thereinvestment of earnings of the company.- Common stock—investment by owners- Additional paid-in capital—investment by owners- Retained earnings—reinvestment of earnings by ownersThe Fundamental Accounting EquationAs the name implies, the balance sheet is a“balance” sheet. The fundamental equationthat rules over accounting balance is:Assets (A) = Liabilities (L) + Owners’ Equity(OE)
  • 210. What you own (assets) equals the total ofwhat you borrowed (liabilities) and whatyou have invested (equity) to pay for it. Thisequation or “identity” explains everythingthat happens in the accounting records of acompany over time. Remember it!Examples of the “Balancing” ActUsing the example of a new localsupermarket called Bob’s Market, I will giveyou three examples of how the balancingact works.
  • 211. 1.When the market opened up for business, Bob purchased a cash register. Assets increased on the left side of the scale, while bank debt, a liability, was also increased on the right to pay for it. The asset increase was balanced by an increase in liability.2.When Bob invested some of his own money and attracted some of his father’s in order to open the market, equity increased on the right side of the scale, and cash, an asset, increased on the left to balance the transaction.3.When the store becomes successful, it will hopefully be able to pay off its bank debt for the register (liabilities reduced on the right). The cash, an asset, would be reduced, thus balancing the transaction
  • 212. on the left.All transactions adhere to this balancingconcept. There is no way to affect one sideof the balance sheet without a balancingentry. The accounting records are thereforesaid to be in “balance” when the assetsequal the liabilities and owners’ equity (A =L + OE). If the records do not balance, anaccountant has made a mistake.The Accounting Process: The Double EntrySystemAs you may have heard, accountants makejournal entries in their books to record eachof a business’s individual transactions.Accountants call their books the generalledger. Using the same balancing conceptshown by accounting’s fundamentalequation, asset additions are placed on theleft side, called a debit. Liabilities and
  • 213. owners’ equity additions are placed on theright side, called a credit. In all cases,journal entries have at least two lines ofdata, a debit and a credit. Entries to reduceassets are placed on the right, a credit, andreductions of liabilities and equity areplaced on the left, a debit. Because of thisright side/left side method, the manualrecord keeping of each account’stransactions resembles a “T,” andconsequently these records are called “T”accounts.Rules for Entries into Accounts
  • 214. To illustrate, at the beginning of the yearBob and his father issued themselves1,000 shares of stock for their initialinvestment of $15,000 in their store. Thejournal entry to record the transactionlooked like this:Balance Sheet Journal Entry #1Similarly a repayment of a debt would bejournalized as:Balance Sheet Journal Entry #2Because each entry to the recordsbalances, at the end of a period of time, theentire balance sheet that summarizes the
  • 215. individual “accounts” and their net endingbalances also balances (A = L + OE).A Balance Sheet ExampleLet’s continue with the local grocery storeexample and see what balances appearedduring its first year of operation.Bob’s MarketFairway, KansasBalance Sheet as of December 31, 2000(the first year of operation)
  • 216. Bob’s statement resembles the typicalbalance sheet of many retail andmanufacturing firms. Three things are worthnoting. The total of assets equals the totalof liabilities and owners’ equity. Second,the assets are on the left and the liabilitiesand OE are on the right, just like the journal
  • 217. entries of debits and credits. The thirdnoteworthy item is that the balance sheet isas of a point certain in time, December 31,2000, a specific date. Even though abusiness is the result of buying and sellingover time, the balance sheet is only a“snapshot” of what the company’sresources and obligations are at a statedtime.Liquidity: Current and Long-TermClassificationsAn important aspect of the balance sheetstatement is that the assets and liabilitiesare listed in order of their liquidity, frommost liquid to least. Liquidity means theability of an asset to be converted to cash.Cash, Accounts Receivables fromcustomers, and Inventory are labeledcurrent and are listed first since they are
  • 218. easily transferred and converted into cashwithin the next operating period, typically inone year (i.e., they are liquid). Equipment isnot very easily sold, therefore it is classifiedas fixed, long-term, or a noncurrent asset(NCA) and listed below the current items.Check out Bob’s balance sheet to verify theplacement of these items.On the liabilities side, the accounts payableto suppliers, wages payable to employees,and taxes payable are current liabilities.They are short-term obligations that willhave to be paid within a year. The bankdebt is long-term or a noncurrent liability(NCL) because it will be paid off over aperiod of years.Working CapitalA commonly used term in accounting aswell as finance is working capital. It refers
  • 219. to the assets and liabilities that a companyconstantly “works with” as part of its dailybusiness. They are also the most liquidassets, giving a financial statement readera clue to a firm’s solvency. Consequently,working capital items are the current assetsand liabilities of the firm. Net workingcapital, a measure of solvency, is the totalof current assets less the total of currentliabilities.Current Assets Current Liabilities = NetWorking CapitalAt Bob’s Market net working capitalamounts to $28,000 ($115,000 $87,000).That’s Bob’s excess of liquid assets tomake good on its current obligations. Froma banker’s vantage point, a grocer with alarge amount of net working capital may beconsidered a good credit risk because the
  • 220. business can make its debt payments.Conversely, it could also show a corporateraider or operations analyst that the storeowner is mismanaging his inventory byholding too many goods on the shelves ortoo much cash in the registers. An astuteoperator would reduce inventory levels andthe cash on hand to more efficient levelsand pocket the difference as a dividend.The proper amount of working capitaldepends on the industry.How Owners’ Equity Fits InOwners’ equity represents the long-termobligation of a company to its owners.Companies are obligated to pay the ownersa return on their investment based on thesuccess of the firm. OE does not carry aset rate of interest or maturity like a bankloan, so it is segregated below the
  • 221. liabilities. Owners are paid only after allother debt payments are made. An owner’sreturn is dependent on the success of thecompany. If debt repayments cannot bemade, the firm can be forced intobankruptcy. The inability to pay a dividendto investors has no such penalty. If thecompany is highly profitable, the ownerswin. If not, they can lose all of theirinvestment. That’s the risk of ownership.By reversing algebraically our accountingidentity from A = L + OE to OE = A L, youcan see that OE is the “residual” interest ofthe firm, assets less liabilities. OE is alsocalled net worth, as it is the “net” value afterall other obligations. In the case of DonaldTrump, the notorious real estate magnateof the 1980s, he may have owned billionsof dollars of property, but temporarily his
  • 222. net worth reportedly became negative in1990 as his debts became even larger thanthe value of his properties in New York Cityand Atlantic City.Owners’ equity is increased by conductingbusiness. Businesses buy and sell andprovide and receive services. Hopefullyafter a period of time, the company hasincreased its wealth with those activities. Ifthe net assets increased over time then itmust have increased its OE.The OE captions on the balance sheet canbe affected in two ways. Investors cancontribute more funds or they may electthat the company “retain” its profits. Theline “Retained Earnings” is on the balancesheet for that purpose. If owners want totake out earnings they may elect to receivedividends. Dividends reduce their
  • 223. accumulated retained earnings.Accountants sometimes prepare theStatement of Owners’ Equity with thefinancial statements if the information isuseful. These detailed statements outlinethe owners’ investments, their stocktransactions, and the dividends paid tothem during the year. These transactionsaffect the owners’ equity captions on thebalance sheet. The Statement of Owners’Equity, also called the Statement ofChanges Shareholders’ Equity, isconsidered a minor statement. However, itmay be very important for companies thathave a great deal of owner activity. Largecompanies always produce this statementbecause it reveals many transactions thatinterest the public. Take a moment and goback to Bob’s balance sheet and review its
  • 224. presentation before you move on to theincome statement.The Income StatementAs the balance sheet shows balances as ofa specific date, the income statementshows the “flow” of activity and transactionsover a specific “period” of time. That periodmay be a month, a quarter, or a year.There are revenues from sales andexpenses relating to those revenues. Whenrevenues and expenses are properlymatched using accrual accounting, thedifference is “income.”Revenue Expenses = IncomeAn Income Statement ExampleLet’s look at the income statement of Bob’sMarket to see how his operation performedduring his first year of business.
  • 225. Bob’s MarketFairway, KansasIncome Statement for the Year EndingDecember 31, 2000
  • 226. Income Statement TerminologyAs with the balance sheet, the incomestatement has several noteworthy features.In the income statement, the classificationsof expenses are extremely importantbecause different types of income arecalculated. Each offers a particular insightabout Bob’s operating results. Please referto Bob’s income statement as you readthrough this terminology section.Gross Margin. The top part of the incomestatement calculates gross margin.Gross Margin =Sales The “Direct” Cost of the Goods orServices Sold
  • 227. At this point, the reader can determine ifthe company is making a profit withoutconsidering the burden of corporateexpenses. At Bob’s Market gross marginwas his sales less the cost of goods sold(COGS). COGS includes the cost ofgroceries and all costs “directly” related tomaking the groceries salable, such as thecost of shipment from the wholesaler. In amanufacturing company it includes thecosts of production, materials, and labor. Ina simple retail situation like Bob’s, COGS iscalculated by this formula:Beginning Inventory + New PurchasesEnding Inventory = Cost of Goods SoldIf a business has a negative gross margin,either costs are out of control, or the pricingstructure of the industry does not afford thecompany a profit. A small electronics
  • 228. manufacturer would encounter this situationif it tried to compete with the Japanesevideo recorder manufacturers, Sony,Hitachi, and Panasonic. A small U.S.manufacturer could not be as efficient andcould not charge a higher price to cover itshigher costs of production.Operating Profit. The next part of theincome statement relates to the operatingprofit of the company, the earnings beforeinterest and taxes (EBIT). The further wemove down the income statement, themore expenses that are deducted. At theoperating level of profit measurement, allthe other corporate expenses directlyrelated to the revenue process arededucted. In Bob’s case he has employeewages, rent, utilities, advertising, and manyother smaller items.
  • 229. Accrual accounting dictates that theallocated cost of fixed assets, also calleddepreciation, be charged to earnings. Usingthe principle of matching, the cost ofproviding the company’s products ismatched with its related revenues of theperiod. Accountants divide the cost ofequipment, tools, buildings, and other fixedassets by their useful lives to estimate thecost of using up assets needed in therevenue-generating process. In Bob’s case,he spent $30,000 for shelves, carts, andcash registers. Because he estimated thatthey will last 10 years, Bob’s incomestatement will show an expense of $3,000($30,000/10) each year to match andallocate the cost of using those assets withthe period of sales benefited.
  • 230. “Other Expenses” is a catchall category foritems not large enough to justify a separateline on the income statement. On Bob’sincome statement it includes fixing thoseannoying stuck wheels on his shoppingcarts and the losses on bad checks.Net Income. Below the operational level ofprofit, items not directly linked to operationsare deducted to calculate income. The firstis the interest expense for the period. Acase can be made that corporate borrowingis used to support the operation. However,the method of financing the company isseparate from the operating activities of thebusiness. Accountants do not includeinterest in operating income, becausecompanies in similar businesses may havebeen funded by using differing proportionsof bank borrowing and investors’ money.
  • 231. Investors’ dividends are not deducted.Owners pay dividends out of the netincome at the bottom of the statement.If interest were to be included in operatingincome, similar companies could havevastly differing operating incomes just bythe way they funded their cash needs. Acompany under a different managementcould fund all its cash needs by additionalinvestments from its owners. These fundswould incur no interest charges, and,therefore, the company’s operating incomewould be higher. If the same companyborrowed for all its needs, its operatingincome would be reduced by the interestexpenses. By segregating interestexpenses, the operating income reflectsonly the costs of “operating” the company,rather than “financing” it.
  • 232. Using the same logic that excluded interestfrom operating income, tax expenses aresegregated to leave operating income freeof nonoperating expenses. Different taxstrategies can result in greatly different taxexpenses. Because taxes are often theproduct of a skilled tax accountant’s peninstead of operating results, tax expensesare put below operating results as aseparate deduction, leaving net income asthe final measure of income. Net income isthe bottom-line profit of the company and itis the figure that is reported in the media asthe measure of success or failure.How Income Statement Journal Entries AreMadeIn keeping with their age-old duty to countthe beans, accountants make journalentries to the company’s books to tally up
  • 233. net income during the year. Net income isthe result of subtracting the expenses fromthe sales made during a defined period oftime. Net income is also the net increase inassets for the same period of time. Journalentries keep track of the total of all therevenues and expenses as well as theircorresponding increases and decreases inassets. Accountants make the entries forthe income statement at the same time asthey prepare the balance sheet.During the year, running totals areaccumulated for each revenue andexpense to calculate the final net incomefigure for the entire year. At year’s endwhen the final tally is completed and netincome is calculated, the running totals ofrevenues and expenses are set to zero forthe new year and the difference or net
  • 234. income or loss is recorded on the balancesheet as retained earnings. Thataccounting year, at times called a fiscalyear, can begin in any month. It does nothave to start in January.The journal entries look the same as thosethat you have seen used for the balancesheet. To track the income statement,revenues are recorded as credits (on theright side) and expenses are recorded asdebits (on the left).Income statement entries are combinedwith balance sheet entries. A sale meansthat the business received something ofvalue, an asset, in exchange for somethingelse of value, an expense. At Bob’s grocerystore, sales meant that an inflow of cashcame in exchange for grocery inventory.Bob’s accountant made weekly entries to
  • 235. record his sales and their costs in thefollowing way:Income Statement Journal Entry #1Similarly the accountant recorded the costof those sales:Income Statement Journal Entry #2To illustrate a full year’s income statemententries, assume that those two entries werethe only sales and costs for the entire year.The net income for the year would havebeen the net of the total sales revenues of$100,000 less the total COGS of $95,000,or $5,000. That net income figure also
  • 236. mimicked the change in net assetsrecorded by those same entries. Cashincreased $100,000 and groceriesdecreased $95,000, a net of $5,000.At year’s end the net increase of assets of$5,000 equals the net income for the year.Bob would have recorded that net changeon the balance sheet as an increase toretained earnings. He would also close outor set to zero all the revenue and expenseaccounts for the year in preparation forrecording the next year’s activity in thefollowing entry:Income Statement Year End Close OutEntry
  • 237. Notice that the journal entry balances. Theincome statement entries reversedthemselves, leaving the net incomeaddition to retained earnings on thebalance sheet. Where sales of $100,000were entered on the right during the year,they are cleared at year end with a$100,000 entry on the left. The balancesheet’s asset, liability, and owner’s equitybalances are permanent running totals thatare carried forward to the next accountingyear. There you have it. In a page you’vewitnessed an abbreviated version of anentire year’s accounting cycle and hours ofMBA classroom consternation.The Income Statement’s Link to theBalance SheetFrom Bob’s actual income statement, thereader can see that the store had a
  • 238. marginally profitable year. He had a netincome of $30,000. What is even moreimportant than just the calculations ofincome is the understanding of how theincome statement relates to the balancesheet. The income statement is the resultof many activities during the year. Assetsand liabilities are affected upward anddownward during the year through manyindividual transactions. At year’s end, thenet assets of the firm, as totaled by thebalance sheet, had changed because ofoperating activities. The net income, ascalculated by the income statement, tellsthe story of the year’s operations byshowing how that change in net assetsoccurred. Because it was Bob’s first year,retained earnings equaled $30,000, the firstyear’s net income. In succeeding years itwill be affected by the next year’s earnings
  • 239. and dividends.The Statement of Cash FlowsThe Importance of CashAs the saying goes, “Cash is king.” Withoutthe green a business cannot function. Forexample, let’s take a look at Leonard, Inc.,who sold package printing equipment to thefood companies that supplied Bob’sMarket. If Leonard, Inc., sold three printingpresses to Ralston Purina at $5 millioneach and earned $2 million on each,Leonard’s income statement would show$6 million in profits. However, Leonardmanufactured the equipment during thesummer and Ralston paid for it in the fallwhen it was delivered. The factoryemployees wouldn’t be too happy if theirJuly paychecks bounced while thecompany waited for the cash in October.
  • 240. Because the cash is critical for operations,and most important in order to stay out ofbankruptcy, the FASB wrote rule No. 95mandating that all financial statementsinclude the Statement of Cash Flows orCash Flow Statement. Remember thoseFASB rules that I mentioned accountantsmake to address current businessconcerns? Because knowing the “sources”and “uses” of cash is paramount for abusiness, the addition of the statement ofcash flows has been widely seen as a greatimprovement by the financial community.The inability to manage a company’s cashneeds is often the primary cause of thedemise of many “profitable” enterprises.Many companies that measured theirsuccess by their net income have had arude awakening when confronted with cash
  • 241. shortages and angry creditors. This is justwhat happened to Chrysler in 1979 when itwent hat in hand to the federal governmentfor a bailout.Investors myopically looking at the incomestatement for a measure of health can bedeceived. For example, McDonnellDouglas, the defense contractor, hadhealthy earnings in 1990 that masked anunderlying corporate illness. Forbesreported it to its readers:On the surface, things don’t look so bad forMcDonnell Douglas. It will probably reportover $10 a share in earnings in 1990,versus $5.72 last year. But even a cursoryglance examination of the numbers showsthat earnings are shaky, if not ephemeral.Start with cash flow. It was negative $35million by the third quarter of 1991…and
  • 242. the bleeding of cash could accelerate….The leveraged buyout (LBO) phenomenonof the 1980s used the principles of cashflow as its tool. A raider’s ability to repaythe money borrowed to acquire a targetcompany was based in large part on thecash flow generating ability of theacquisition. Much of that information lies inthe statement of cash flows. In 1989Kohlberg Kravis Roberts (KKR) boughtRJR Nabisco in the largest leveragedbuyout up to that time with $26.4 billion indebt financing based on the cash-generating ability of the company to pay offthe debt.The Cash Flow Statement’s Link to theBalance SheetThe cash flow statement also follows thebalancing act principle of accounting. I will
  • 243. present the accounting math first so thatyou may understand the logic of what, atfirst glance, can be a confusing statement.With the math out of the way, the cash flowstatement example can be readilyunderstood. The equations that follow arenot included to impress, merely to inform.Using the golden fundamental accountingequation we have:A = L + OEAssets = Liabilities + Owner’s EquityBecause assets and liabilities arecomposed of both current (short-term) andnoncurrent (long-term) items, the equationcan be expanded:CA + NCA = CL + NCL + OE
  • 244. Current Assets + Noncurrent Assets =Current Liabilities + Noncurrent Liabilities +Owners’ EquityTo further break it down, the current assetclass can be shown as its individualcomponents:(Cash + Accounts Receivable (AR) +Inventory (INV) + NCA = CL + NCL + OERearranging the equation algebraically, wecan isolate cash:Cash = CL + NCL + OE AR INV NCAAs revealed by the equation, an increase ina current liability (CL) on the right of theequals sign would mean an increase incash on the left. Increasing your debts tosuppliers frees up a business’s cash forother purposes. Conversely an increase inan asset such as Inventory would mean a
  • 245. decrease in cash. It makes sense; buyinginventory requires cash. Adding orsubtracting on one side of the equals signaffects the total on the other side of theequation.My study group at business school foundcash flow statements to be the mostconfusing of the major topics in accounting.But if the former Peace Corps volunteer inmy study group with no business trainingcaught on, I have full confidence in yourability to pick it up also. With the precedingas foundation, I will illustrate theimportance of the cash flow statement anduse Bob’s Market as an example to finishoff the cash flow lesson.The Uses for the Cash Flow StatementThe cash flow statement is a managementtool to help avoid liquidity problems. Both
  • 246. the income statement and the balancesheet are used to form the cash flowpicture of a company. The statementanswers the following important questions:What is the relationship between cash flowand earnings?How are dividends financed?How are debts paid off?How is the cash generated by operationsused?Are management’s stated financial policiesreflected in the cash flow?By using a statement of cash flows,managers can plan and manage their cashsources and needs from three types ofbusiness activities:
  • 247. Operations ActivitiesInvesting ActivitiesFinancing ActivitiesThese activities are shown clearly in thecash flow statements.A Cash Flow Statement ExampleLet’s look at Bob’s Market as a springboardfrom my theoretical discussion and get intoan actual cash flow statement.Bob’s MarketStatement of Cash Flows for the yearEnding December 31, 2000
  • 248. It is easy to get too wrapped up in thenumbers and not really grasp the logicbehind the preparation of the statement.Therefore, let’s look at each entryseparately and explain the logic behind it.The MBA’s accounting education focuseson the logic behind the numbers, whileundergraduate programs focus primarily onthe accounting mechanics to turn outCPAs, not MBA managers.Please refer to Bob’s cash flow statementduring the following discussion.Operating ActivitiesIn the Operating Activities section,accountants calculate the cash generatedfrom the day-to-day operating activities of abusiness. The income statement showed
  • 249. “accounting profit” of $30,000 for Bob, but itdid not show how much cash was used orgenerated by his operations. As I explainedearlier, most companies use accrual basisaccounting, as Bob has, to determine hisnet income. The cash flow statementconverts that accrual basis net income to acash basis. To do that the net income hasto be adjusted in two ways to get back to acash basis.Step 1. Adjust Net Income for NoncashExpenses. The first step to determine theflow of cash is to adjust the net incomefrom the income statement. Operatingitems that did not use cash, but werededucted in the income statement as anexpense, must be added back.Depreciation, as explained in the income
  • 250. statement section, does not actually takethe company’s cash “out the door.” Onlywhen Bob purchased the carts, registers,and displays was cash used. But over thelife of these assets, depreciation is only an“accounting cost” that matches the originalcash expenditure for these assets with thesales they benefit. Therefore, depreciationmust be added back. It is not a use of cash.The purchases of the assets themselvesare included later in the Investing Activitiessection.Step 2. Adjust Net Income for Changes inWorking Capital. Net income must also beadjusted for the changes in current assetsand current liabilities that operationalactivities affected during the year. Byadjusting net income for working capital
  • 251. increases and decreases, we candetermine the effect on cash by using thefundamental accounting equation.When Bob increased his current assets,such as his shelf inventory, he used cashbecause it took cash to buy groceries. Thisis shown as subtractions on the cash flowstatement. When he extended credit to hiscustomers, it delayed his receipt of cash,thus “using” cash that the store could havebeen using for other purposes. This is alsoshown as a subtraction on the statement.Conversely, reductions in inventory, i.e.,sales, would have increased Bob’s cash. Ifreceivables had declined, i.e., customers’payments, cash would have beengenerated. Point of Learning: Increases incurrent assets use cash while decreases incurrent assets produce cash.
  • 252. Current liabilities changes have theopposite effect on cash. In Bob’s case hisvendors advanced him $80,000. When Bobran up a large debt with his vendors andemployees, this meant that credit wasextended to him, which in turn freed hiscash for other purposes. In a sense, cashwas created. If Bob had reduced hisliabilities, that would have meant that hehad made payments to reduce his debts,reducing cash. Point of Learning: Increasesin current liabilities increase cash whiledecreases use up cash.To calculate the net changes for the year,simply subtract the beginning of theperiod’s balances of current assets andliabilities from the ending balances items.Because it was Bob’s first year (and tomake it simple), the beginning balances
  • 253. were all zero and the ending balances areequal to the account increases for the year.The increases in current assets are “uses”and the increases in current liabilities are“sources” of cash.Convince yourself that Bob’s cash flowstatement is correct. Refer to his cash flowstatement. Look back at the incomestatement to verify the net income. Reviewthe balance sheet to check that thechanges in the working capital items (CA +CL) equal the changes shown on the cashflow statement. It all fits together!Investing ActivitiesAs the title explains, this area of the cashflow statement deals with cash use andgeneration by long-term “investments” bythe company. Accordingly, the investmentactivities section reflects the cash effects of
  • 254. transactions in long-term (noncurrent)assets on the balance sheet. When acompany buys or sells a long-term assetlike a building or piece of equipment, thecash relating to the transaction is reflectedin the Investing Activities section of thecash flow statement. In Bob’s case, heinvested $30,000 in store equipment asshown on his statement. If he had sold theequipment, the cash received would havebeen reflected. Review the balance sheetto verify how the change in his long-termassets was reflected in the investingsection of the cash flow statement.Financing ActivitiesThere are two ways a company can financeitself. Either managers borrow money orthey raise money from investors. Borrowingwould be reflected in changes in the long-
  • 255. term liabilities section of the balance sheet.The participation by investors would bereflected in changes in the owners’ equityaccounts of the balance sheet.Bob borrowed $10,000 from the bank,which increased Cash. On the balancesheet, “Bank Debt” increased from $0 to$10,000 and it was reflected as a source ofcash. When the store repays the debt, it willbe reflected as a use of cash in theFinancing Activities section.Referring back to Bob’s Market’s balancesheet, the owners’ equity accounts are onthe right side. The balance sheet showsthat investors contributed $15,000 cash tostart the business. That is shown on thebalance sheet as “Common Stock” issued,and it is also reflected on the cash flowstatement as a source of cash.
  • 256. As we have already learned, the othercomponent of the owners’ equity section isretained earnings (RE). As explained, therewill be changes in RE when net income isadded during the year and if dividends arepaid out to investors. Bob and his fatherelected to continue to “finance” thebusiness by having the company “retain” itsearnings. The financing section,accordingly, does not show any dividendpayments. If the owners elected to pay adividend it would have been shown as ause.After a year of operations Bob had $5,000more than when he started. With his cashflow statement he can understand how ithappened!Once prepared, what does the cash flowstatement mean?
  • 257. Take a step back, or else you can get lostin the mechanics. This cash flow statementshows the net change in cash for the year.It appears at the bottom of the statement.Take a look. It sounds simple, but somenewly minted CPAs I worked with at ArthurAndersen LLP never really understood thatfact as they labored to prepare the report’sdetails. You do. Where the changes in cashtook place is of real importance to MBAs.Was the company a seemingly profitablecompany, but must borrow heavily just tostay alive?Did the company’s operations throw offcash, even though it may be just marginallyprofitable according to the incomestatement?
  • 258. Those are samples of the importantquestions that neither the balance sheetnor the income statement can tell a reader.That is why the cash flow statement exists.When a company is healthy, operatingactivities will generate cash. That messageis delivered by the net income adjusted forchanges in working capital. That is theOperating Activities section’s function.Does the company require a greatinvestment in fixed assets such as newequipment or technology? Is the companyselling off its assets to fill an insatiable cashdrain from operations? That type ofinformation lies in the Investment Activitiessection.Dying businesses stay alive bycannibalizing their assets to fund their
  • 259. unprofitable operations. Pan AmericanAirlines withered in 1991 when it sold itscoveted European routes to its competitorsto raise cash. Pan Am died in 1992. Theairline of the same name today bought thename from the bankrupcy court.Did the company borrow heavily or has thecompany gone to investors to fund itsoperational or investing activities? TheFinancing Activities section tells thatimportant story. In Bob’s case he borrowedfrom the bank and invested his own money.Whatever the sources and uses of cash,the statement of cash flows tells a greatdeal about a business’s health. To manyfinancial analysts, it is the most importantstatement of all.
  • 260. Accounting’s Big PictureA knowledgeable person can always getback to the fundamental equation ofaccounting to make sense of any jumble ofnumbers making up any of the financialstatements of a company: Assets =Liabilities + Owners’ Equity.With the statement of cash flows it wasdemonstrated that the changes during theyear in the cash balance had to result fromchanges in assets, liabilities, and owners’equity. The assets and liabilities changescame from the balance sheet. The owners’equity changes were the result of changesin net income, provided in detail by theincome statement. The three basic financialstatements are inextricably tied together.The fundamental accounting equation, thebalance sheet, and each of the many
  • 261. journal entries made during the year alwaysbalance. That fundamental property allowsfor changes in any piece of the accountingpuzzle to be explained by changes in theother parts. By grasping this basic conceptof the interrelationships of the financialstatements, you have learned the essenceof accounting. Congratulations! Reading the Financial Statements Using RatiosWith an understanding of how accountantscreate their financial statements, let me addsome tools to interpret them: ratios.Absolute numbers in a financial statementin and of themselves often are of limitedsignificance. The real information can befound in an analysis of the relationship ofone number to another or of one companyto another in the same industry—using
  • 262. ratios. In the grocery game, profits areusually low in relation to sales, so grocersmust sell in large volume to make any realprofit. A jewelry store survives on slower-paced sales but higher profits per item.That is why ratios are used to compareperformances among companies within anindustry and against a company’s ownhistorical performance.There are four major categories of ratios:Liquidity measures: How much is on handthat can be converted to cash to pay thebills?Capitalization measures: Is a companyheavily burdened with debt? Are itsinvestors financing the company? How isthe company funding itself?
  • 263. Activity measures: How actively are thefirm’s assets being deployed? (MBAsdeploy assets, rather than just use them.)Profitability measures: How profitable is acompany in relation to the assets and thesales that made its profits possible?There are literally hundreds of possibleratios, but most have their origin in eightbasic ratios from the four categories listedabove. Using Bob’s financial statements, Ihave calculated these eight ratios for hisoperation and have placed them beloweach of the ratio explanations.Liquidity Ratios1. Current Ratio = Current Assets / CurrentLiabilities
  • 264. Can the company pay its bills comfortably?A ratio greater than 1 shows liquidity. Itshows that there is leeway in the currentassets available to pay for current liabilities.Capitalization Ratios2. Financial Leverage = (Total Liabilities +Owners’ Equity) / OEWhen a company assumes a largerproportion of debt than the amount invested
  • 265. by its owners, it is said to be leveraged. Ina profitable company, by using a higherlevel of debt, the return is much higherbecause a smaller amount appears in thedenominator of the ratio. The “same”amount of earnings is divided by a smallerequity base. Ratios of greater than 2 showan extensive use of debt. I will explainleverage more fully when discussing theprofitability ratios.3. Long-term Debt to Capital = Long-termDebt / (Liabilities + OE)Because debt payments are fixedobligations that must be paid whiledividends to investors are not, the level of
  • 266. debt is a very important measure of acompany’s riskiness. A ratio of greater than50 percent shows a high level of debt.Depending on the timing and stability of afirm’s cash flows, 50 percent could beconsidered very risky. Stable electricutilities have predictable sales and cashflows; therefore, ratios over 50 percent arecommonplace. Investment analysts on WallStreet consider those debt levelsconservative.Activity Ratios4. Assets Turnover per Period = Sales /Total Assets
  • 267. This ratio tells the reader how actively thefirm uses all of its assets. The firm that cangenerate more sales with a given set ofassets is said to have managed its assetsefficiently. Ratios are industry-specific.Thirty-six is a high turnover of assets formost industries, but for an antique shop aturnover of three may be considered veryhigh. One-of-a-kind antiques sit waiting forthe right collector to come along. In thegrocery trade 36.6 turns per year is normalbecause the shelf inventory of asupermarket is sold about every week. Theproduce, milk, and toilet paper inventoryturn over several times a week, while theexotic spices take much longer to sell.5. Inventory Turns per Period = Cost ofGoods Sold / Average Inventory HeldDuring the Period
  • 268. (A simple way to calculate “AverageInventory” is by adding the beginning andending inventory balances, then dividing bytwo.)6. Days Sales in Inventory = EndingInventory / (Cost of Goods Sold / 365)These two activity ratios show how activelya company’s inventory is being deployed. Isinventory sitting around collecting dust or isit being sold as soon as it hits the shelf? Ina high-turnover business, like the grocerytrade, there are many turns of inventory
  • 269. during a year and only a few days ofinventory on hand. Most grocery items areperishable and purchased frequently.Profitability Ratios7. Return on Sales (ROS) = Net Income /Sales“Return” ratios are very easy to calculateand investment analysts use themfrequently. They calculate the return on justabout any part of the balance sheet andincome statement. Another common one isthe return on assets (ROA).8. Return on Equity (ROE) = Net Income /Owners’ Equity
  • 270. The mix of debt and equity can dramaticallyaffect the ratios. If a company has a highlevel of debt and a small amount of equity,the return on equity (ROE) can betremendously affected. That is calledfinancial leverage, the term that Imentioned before in discussingcapitalization ratios. To illustrate the point,Bob and his father could have decided toleave very little equity in the company in2000. They could have taken all of the$30,000 of net income made in 2000 out ofthe company as dividends and borrowedfor their future cash needs. If that hadhappened, the balance sheet would havereflected a long-term debt balance of
  • 271. $40,000 ($10,000 + $30,000) and only$15,000 ($45,000 $30,000) in equity. Theresulting debt to equity ratio would increasefrom 7 percent to 28 percent and the returnon equity would have increased from 67percent to 200 percent ($30,000/$15,000).As shown, ratios can be greatly affected bythe financial leverage used. The choice of alower equity level can “leverage” the ROEto extremely high levels.ROE ratio is a widely accepted yardstick tomeasure success. In Forbes’s “AnnualReport of American Industry,” companieswith the greater ROEs were ranked higherthan many of their more profitablecounterparts simply because of theirfinancing choices. If management’s goal isto achieve a higher profitability ratiothrough leverage, there is a risk cost.
  • 272. Higher debt levels require higher interestpayments that a company may not be ableto service if operations do poorly. Thecorporate failures in the 1990s of RevcoDrugs, Southland’s 7-Eleven, andFederated Department Stores were casesin which management risked bankruptcywith high leverage and lost.The Du Pont ChartAcademics have a tendency to giveimposing names to simple concepts. YourMBA vocabulary would not be completewithout including the Du Pont Chart. Thechart shows how several of the mostimportant financial statement ratios arerelated to one another by displaying theircomponents.By charting the interrelationships amongratios, one can see that changes in a
  • 273. component of one ratio affect the otherratios. The ratios share the same inputs.For example, when Total Assets isreduced, both the Asset Turnover andReturn on Assets ratios increase becauseTotal Assets are included in the calculationof both of those ratios as a denominator.Conversely, a reduction of Total Assets(equal to total liabilities and owners’ equity)decreases Financial Leverage as it is usedin that ratio’s numerator.The Du Pont ChartRatios are Industry-Specific
  • 274. Profitability is, as in the case of all otherratios, very industry-specific. Every industryhas a profit level depending on the physicaldemands of the industry. Heavymanufacturers such as steel makers have areturn on assets (ROA) of less than 10percent. They have large steel mills and agreat deal of factory equipment. Servicebusinesses such as profitable head-huntingfirms may have ROAs over 100 percent.The only assets they need are cash, officefurniture, and customer receivables. Theirreal asset is their staff’s talent for nursingand persuading, which cannot be quantifiedon the balance sheet.Profitability also depends on the level ofcompetition. In the grocery business,intense competition keeps the return onsales to a very low 1 percent. During Bob’s
  • 275. first year he had a .58 percent return, whichwas below the industry average.Considering that it was his first year, anyprofit should be commended.Any part of the financial statements can becompared to another with a ratio of somesort. Any calculator can divide one numberby another. Only those ratios that canprovide some insight into a business’sperformance are valuable. The true valueof ratios is seen when one firm’s ratios arecompared to those of another in the sameindustry, or to that firm’s historicalperformance. Alternatively the“attractiveness” of various industries asbusiness opportunities may be explored bycomparing their averages. Each firm andindustry has its own key operating statisticsthat are meaningful.
  • 276. For industry-specific references on all theseratios, Robert Morris Associates publishesits Annual Statement Studies. This valuablereference book, available in most libraries,includes financial and operating ratios forover 300 manufacturers, wholesalers,retailers, services, contractors, and financecompanies. Managerial AccountingManagerial accounting, like ratio analysis,uses accounting data to manage andanalyze operations. Managerial accountingfocuses on operations. Instead of ratiosmanagerial accounting uses standards,budgets, and variances to run the businessand explain operational results. The objectof managerial accounting is to budget acompany’s activities for a period of time,and then to explain why the actual results
  • 277. “varied” from the projections. In mostmanufacturing settings, monthly budgetingand analysis are the norm so thatmanagement can take timely action.To establish a yardstick for measuringperformance, the factory team must setstandards for comparison. This requires theinput from more than just the accountants.In automobile manufacturing, theproduction manager establishes what he orshe believes should be the standard costsfor materials, labor, and other expenses.Industrial engineers help by performingstudies to obtain the data. Factorymanagers work with sales managers tobudget production volumes to meetforecasted demand and also to maintainassembly line efficiency. Sales managersset standard prices and quantities for their
  • 278. products. Using those standards as ayardstick, managerial accountants analyzeactual results to explain the variances fromthose budgets and standards thecompany’s team developed. Oncecompleted, variance analysis highlights thesource of positive or negative results formanagement decision making.Price and Volume VariancesThere are two basic types of variances,price and volume variances. As withfinancial statement ratios, they are derivedfrom simple mathematical formulas.Sales Price Variances. The price variancetells the manager how much of thedifference between budgeted salesrevenue and actual sales revenues is dueto changes in sales price changes.
  • 279. (Actual Sales Price Standard Sales Price)× (Actual Quantity Sold) = Sales PriceVarianceSales Volume Variances. The volumevariance isolates the dollar effect of adifferent unit volume from what wasbudgeted assuming no price changes.(Standard Sales Price) × (Actual QuantitySold Standard Quantity Sold) = SalesVolume VarianceUsing a hypothetical example,DaimlerChrysler AG planned to sell 10,000Dodge Caravan minivans in July 2001 at aprice of $20,000 each for a total of $200million in sales. In August the analystreceived accounting data showing thatsales were actually $380 million in July.Dodge actually sold 20,000 Caravans at anaverage price of $19,000 due to a $1,000
  • 280. rebate program. The total variance of saleswas $180 million. (10,000 × $20,000)(20,000 × $19,000). How did that occur?Variances told the story.The variance solely due to price, the pricevariance, was a negative $20 million($19,000 $20,000) × 20,000 units). Butbecause 10,000 more units were sold thanplanned, the volume variance was a verypositive $200 million ((20,000 10,000 units)× $20,000). The two variances ($20 + $200= +$180) equaled the total variance fromthe total sales budget ($280 $150 =+$130). The variance analysis told theDaimlerChrysler executive in charge of theCaravan model that the overall increase insales was primarily due to a larger salesvolume, rather than to a price increase.Conversely, the small negative price
  • 281. variance due to a rebate was more thanmade up by a stronger sales volume. Whenyou add together the price and the volumevariances they equal the “total” monthlysales variance from budget. The varianceanalysis enabled the Dodge executive toexplain why his results hit his division’stargets.Purchase Price, Efficiency, and VolumeVariancesUsing the same two basic formulas, salesprice and sales volume variances,production departments also calculatevariances for management control.Purchases and usage of productionmaterials have purchase price variances.Purchase Price Variance = (Standard PriceActual Price) × (Actual Quantity Purchasedor Used)
  • 282. The amount of materials and labor used toproduce products may also differ from thestandard amount. Similar to sales volumevariances, these differences are calledefficiency variances. Shoe workers, forexample, can be more efficient by usingmore leather from a hide than planned.Chemically dependent workers on theassembly line in Detroit could take morelabor hours than planned to produce theircars.Material or Labor Efficiency Variance =(Standard Use Quantity Actual UsageQuantity) × (Standard Cost of Material orLabor)Using the Caravan again as an example,the production foreman had budgeted inJuly that each Caravan made should use astandard 8 gallons of paint at a cost of $10
  • 283. per gallon. It actually took 7 gallons at acost of $12 per gallon for the 20,000minivans that were produced. Theaccountant calculated the followingvariances for the Dodge executive:Material Price Variance = ($10 $12 priceper gallon) × (20,000 units × 7 gal.) =$280,000 negative paint price varianceThis was the effect of paying more pergallon than planned. Instead of scratchinghis head, the Dodge executive could usethis information to confront his purchasingagent and demand that he negotiate abetter deal the following month.Material Efficiency Variance = (8 gal. 7gal.) × (20,000 units) × $10 per gallon =$200,000 positive variance
  • 284. This was the effect of using less paint thanplanned.As with ratios, there is an infinite number ofvariances that can be cooked up to keep adepartment of accounting analysts busyfrom now until the next century. There arebasically only two types of variances: priceand volume variances. When you hear thewords “managerial accounting,” thinkvariances.Cost Accounting and Activity- Based CostingCost accounting is the relativelystraightforward process of determining thecost of producing goods and services. It isclosely associated with managerialaccounting, as all its “standards” are basedon the data gathered by cost accountants.
  • 285. With manufactured goods, direct labor anddirect materials are relatively simple toallocate to the cost of a product. However,allocating overhead is much more difficult.More important, if not done properly, it mayfalsely determine profitability of individualproducts and divisions of companies.Overhead must be allocated based on theactual usage of the overhead expenses;hence it is called activity-based costing(ABC). Overhead should be allocatedbased on what it takes to create and deliverthe product to the customer. In the past,overhead expenses were a relatively minorcomponent in relation to materials andlabor costs, but today expenses such astelephone, billing, consultants, andcomputer systems are huge.
  • 286. For example, if a high-revenue division of acompany makes sales to a few vendorswith few orders, it should be allocated lessof the cost of the billing department’s costthan a lower-sales division that has manysmall customers ordering many times ayear. If accountants allocate based onsales, not volume of transactions, the profitpicture would be distorted. When amanufacturing process of a product ishighly automated and that of anotherproduct is not, allocation of computersystem expense based on direct laborhours would be misleading. What oftenhappens in a company is that accountants,detached from the business, arbitrarily ormechanically allocate overhead expenses.That distorts the financial results thatmanagers live or die by. Entire productlines and divisions can be shut down and or
  • 287. outsourced because of these relatively“unimportant” allocation decisions thatneglect their ABC’s. Accounting OverviewI hope you have not struggled too hardthrough this chapter, but in a few pages Ihave tried to give you the essentials ofaccounting from both my CPA backgroundand the MBA curriculum. If the material inthis chapter was totally new for you, mostprobably you have not absorbed itcompletely. You should have rememberedthat:- Assets = Liabilities + Owners’ Equity- There are three basic and interdependent financial statements: Balance Sheet, Income Statement, Cash Flow Statement.
  • 288. - Accounting records and statements always balance.- The statements can be interpreted by using Ratios.- Operating results can be analyzed and managed using Variances.That’s the accounting game in a nutshell.At MBA school accounting struck the mostfear in the hearts of the liberal artsundergraduates. This chapter has givenyou, in a tidy predigested form, what keptthem up late at night. Key Accounting TakeawaysCash Basis Accounting—The method ofrecording transactions only when cashchanges handsAccrual Basis Accounting—The method ofrecording transactions that matches
  • 289. revenues and expenses regardless of cashflow movementsThe Balance Sheet—The listing of what acompany owns and owes at a point in timeThe Fundamental Accounting Equation—Assets = Liabilities + Owners’ EquityNet Working Capital—Short-term assetsless short-term liabilitiesThe Income Statement—The summary ofprofit-generating activities during a periodof timeGross Margin—Revenues less the directcost of goods soldThe Statement of Cash Flows—Thesummary of how a company generates anduses its cash during a period of timeDepreciation—The cost of using equipmentallocated over its useful life
  • 290. The 8 Basic Ratios for Financial StatementAnalysis—A method of analyzingstatements and comparing them to industrystandardsPrice and Volume Variances—A method ofexplaining operational results by isolatingthe effects of price and volume differencesfrom budgeted amountsActivity-Based Costing (ABC)—The methodof allocating overhead expenses based onactual usage, not on arbitrary measure Day 4 Organizational Behavior Organizational Behavior Topics
  • 291. Problem-Solving ModelPsychology LessonMotivationLeadershipCreativityOn-the-Job Office ProcedurePowerThe Organizational Model and StructuresSystems TheoryOrganizational Evolution and RevolutionResistance to ChangeNEW MBA GRADUATE: I have the answer!My Excel spreadsheet says that we shouldreorganize the company by geographicregion rather than by product. We couldsave at least three million dollars a year bycutting unnecessary staff and travel. We
  • 292. hypothetically implemented a similar plan atthe Brandon Lee Company in a classdiscussion. It worked real well.BOSS: Sounds great. You’ve been with thecompany seven months and you want to doa radical reorganization. I assume youalready assembled a roster of redundantemployees?NEW MBA GRADUATE: Well, I’ve notthought it through that far yet.Organizational Behavior (OB) classesattempt to teach MBAs how to deal with thehuman challenges in the workplace.Quantitative skills may provide the magictheoretical pill in the classroom, but OBtries to instill in young MBA turks thehuman sensitivity to apply their MBA skillsin the real world.
  • 293. Many organizational theories are not unlikewhat you can find in books about self-awareness and sensitivity training at thelocal B. Dalton or Waldenbooks. Thereason for the similarity is that many ofthose books are written by the very sameprofessors who propound the academictheories that appear in MBA curricula. Thedifference is that faddish books about the“new” corporate rejuvenation theory or the“one-second manager” make more moneythan articles that appear in obscureacademic journals.Organizational behavior, the “touchy-feelie”subject, is often where MBAs show theirtrue colors. Sexism, prejudice, and greedrear their ugly heads in classes whenseemingly open-minded students attemptto cope with the cases at hand.
  • 294. Regardless, the classes are a welcomerelief to overworked MBAs. There is noneed for intricate quantitative analysis orextensive reading. As with other MBAsubjects, knowing the vocabulary and usingit at the right moments goes a long way inestablishing credibility on the job.What is taught in the OB classes, ifinternalized, are the lessons that well maybe the most influential in the careers ofMBAs. Without people skills, MBAs areequipped with the power tools but arewithout the electric cord to use them. The OB Problem-Solving ModelJust as marketing offers seven steps tomarketing strategy development, OBprovides a three-step technique to solve
  • 295. organizational problems.Problem DefinitionAnalysisAction PlanningProblem DefinitionThe first step to solving an organizationalproblem is to know the source of thedifficulty. Real problems are often maskedby symptoms. It is easy to be misled intosolving the symptoms instead of theircause. Unless the cause is dealt with, freshheadaches will undoubtedly arise. MBAsare taught several analytical techniques toaid in flushing out the sources of trouble.Want Got Gaps. There is a problem when agap or “deviation” exists between what a
  • 296. manager thinks “ought” to be occurring andwhat is “actually” occurring. Defining theproblem entails viewing situations from theperspectives of all the participants andoutlining their Want Got Gaps.In the wake of a failure to introduce acritical new computer technology, a largeservice organization hired a new vice-president, Hank Helpful, to lead thecomputer department out of its trouble. Inhis judgment the problem was caused byinterdepartmental rivalries. He felt that thecomputer department was isolated andalways at odds with the rest of thecompany. Hank saw the gap as follows:I Want Gap I GotInterdepartmental Cooperation GapIsolated Departmental Islands
  • 297. The VP felt that other gaps existed as well.The computer department believed itlacked the respect of the operational arm ofthe company. The people in the departmentfelt that they were being treated as second-class citizens. Both perceptions were true.But the other sales and operatingdepartments had their own gaps. Theywanted timely computer services at anaffordable cost.In many instances, organizational problemsare less easily diagnosed. Often managersdo not know exactly what the gap is. Isthere a gap at all? A manager’s perceptionscan cloud what is “actually” happening.That is often the cause of trouble in the firstplace.The Level of Problems. When you knowwhat gaps exist, it is then important to
  • 298. understand the ways in which they affectthe organization. Problems can affect acompany in three ways:- Within or between certain people- Within or between groups- Within the whole organizationIn the case of the computer departmentdescribed above, the problem existed at allthree of these levels. Each level had to beaddressed to successfully “solve” it. Thehard feelings between individuals occurredat a personal level. The interdepartmentalsquabbling was an intergroup problem. Thecompany’s failure to adopt competitive newtechnologies occurred at the organizationallevel.Source Problems and Causal Chains. Thegoal of an effective MBA is to find the mostimportant problems and solve those first.
  • 299. Those are called the source problems.Eliminate the source, eliminate thesymptoms. Source problems, such as thelack of respect for the computerdepartment, caused a multitude of otherproblems.A graphical method used to get at sourceproblems is to draw a causal chain. Using acausal chain, the company’sinterdepartmental problem would look likethis:Contributing Problems Source ProblemBusiness ProblemLack of Interaction: Personality DifferencesLack of Respect for Techies ProjectFailures
  • 300. AnalysisAfter defining the gaps and using causalchains, the MBA is taught to link theproblems to their causes. In addition todrawing causal chains, during thisanalytical step you try to understand thecauses. Why do they exist? Whatenvironmental factors play a role? Byasking these types of questions you canbegin to confront which causes can becorrected through management action. Ifone problem is insurmountable, differentsolutions have to be tried. In the exampleabove, firing uncooperative people was anoption for the vice-president. Sensitivitytraining and interdepartmental discussionswere other possibilities. As in a marketingplan, there are many possible avenues foraction available to achieve a successful
  • 301. resolution to a problem.Action PlanningMBAs are taught to be decisive andproactive—a frequently used MBAadjective. After a thorough analysis, MBAsshould be able to formulate a plan. Theaction plan has six important steps.1.Set Specific Goals.2.Define Activities, Resources Needed, Responsibilities.3.Set a Timetable for Action.4.Forecast Outcomes, Develop Contingencies.5.Formulate a Detailed Plan of Action in Time Sequence.6.Implement, Supervise Execution, and Evaluate Based on Goals in Step One.
  • 302. As you can imagine, solving problemsMBA-style is not simple. It requires timeand effort. To add to your MBA vocabulary,you should refer to your menu of possibleactions as action levers. This sounds veryforceful and progressive. An action levermay be a reward, a control, or a planningsystem.The idea behind OB is to train MBAs toavoid tactical errors because they failed totake into consideration the people involved.With a framework to tackle challenges, theMBA curriculum inculcates in its studentsthe theories and methods of the day so thatthey can use them.Individual and Organizational Level OB Topics
  • 303. The previous discussion covered theframeworks used to analyze a problem andimplement a solution. The next sectionsdeal with the topics that provide thebackground for that process. The MBAcurriculum logically starts with the theoriesand topics that deal with the individual, thenbuilds to larger organizational issues thatbecome progressively complex with theaddition of more people. Along the way,students are asked to apply their newlyacquired skills to analyze and plansolutions to increasingly complex andchallenging case situations.The MBA Psychology Lesson: The APCFBModelIn the effort to gain an insight into whypeople act the way they do at work, theMBA curriculum includes some form of the
  • 304. APCFB model pictured here. This modelattempts to explain the cognitive process oflinking external events to employeebehavior. Assumptions affect theperceptions people have. Thoseperceptions affect the conclusions. Andthose conclusions prompt feelings.Ultimately those feelings drive behaviorsthat managers observe. By trying tounderstand this process, MBAs may have achance to influence positive behaviors inthemselves as well as in their co-workers.The model looks like this:The APCFB Psychology Model
  • 305. “Why People Behave the Way They Do,”Case UVA-OB-183, Figure 5. Copyright ©
  • 306. 1986 by the Darden Graduate BusinessSchool Foundation, Charlottesville, Virginia.Given an analytical tool, MBAs are made tobelieve that they can understand anything.However, confounding forces within peopleprevent perfect communication andunderstanding. We all see through filtersthat often prevent us from perceivingevents accurately. Filters also prevent usfrom acting out our true desires. We allhave internal defense mechanisms that actas additional filters to protect us frompsychological damage. They also preventan accurate psychological reading of otherpeople. For example, if an insecuresupervisor has a poor aptitude for numbers,then by way of defense, he may find faultwith an analyst’s technical presentation.That would help him avoid confronting his
  • 307. own ineptitude with numbers.MBAs have a chance to affect assumptions, the beliefs we hold about the way theworld or other people or ourselves shouldor ought to be. These assumptions makeup our value system. Listed in order ofease of accessibility, assumptions include:ExpectationsBeliefsValuesExpectations and to some extent beliefscan be changed through clear managementintent and action. Values are deeply heldassumptions that may be altered, if at all,only in time.
  • 308. When a manager is able to tap into thevalues of subordinates, then realproductivity may result. Personally, I placea high value on creativity and freedom.When my manager taps into that well insideme, he elicits my best work. For example,when my boss seeks an insightfulmarketing analysis, he presents me with anopportunity to express my creativity. Ourgoals are said to be congruent orequivalent because we are both aiming atthe same thing. The desired behavior isproduced. Goal congruence among theindividuals of an organization makes thegroup productive. “Goal congruence” is apopular MBA phrase—it sounds great, andit is in fact meaningful.Let’s take the example of a strategicplanning manager. He wanted to tap his
  • 309. team’s creativity in developing plans tocompete in an evolving marketplace. In thepast, he had done all the creative workhimself. His staff members were simplyused to crunch numbers. To elicit a changein their behavior, he had to learn to toleratethe trial and error that are part of thecreative process. Because staff failures inthe past had been met with firings andridicule, the team understandably would beslow to comply with his wishes. The staff’sassumptions stood in the way. To effect thedesired change, he needed to build trust byrewarding creative behavior on a consistentbasis.The bottom line is that understanding a bitof psychology is useful if you wish tomotivate people.
  • 310. Expectancy Theory of MotivationMotivation is an elusive animal that allorganizations want to capture. Expectancytheory outlines the factors that producemotivation with individuals. Managers, staff,and even you can use expectancy theory toattempt to understand employees’behavior.Motivation = Expectation of Work will leadto Performance × Expectation Performancewill lead to Reward × Value of RewardThis equation may be helpful in isolatingthe source of a problem. Each of theequation’s components can explain someaspect of motivation. If a marketingmanager of a declining make of automobile
  • 311. has been losing market share to a better-manufactured and better-promotedcompetitor, he might feel that no matterwhat he does he will fail. That naturallywould decrease his motivation. If thecompany never rewarded superiorperformance, that would also lead todiscontent. And finally, if the reward weresimply a set of keys to the executivewashroom, then a manager might think ofworking elsewhere.Three academic heavyweights, Hertzberg,Maslow, and McClelland, believe thatbehavior is motivated by the urge to satisfyneeds. Fred Hertzberg posits thatmotivation will be enhanced by maximizingthe motivators or satisfiers on the job andminimizing the dissatisfiers or maintenancefactors. A promotion or an award can be a
  • 312. satisfier. Maintenance factors don’tnecessarily bring happiness, but they areexpected. A safe place to work and a livingwage are typical maintenance factors.Abraham Maslow sees employeemotivation as a function of meeting anemployee’s hierarchy of needs. Thehierarchy is frequently depicted as apyramid. The need for food and water is atthe bottom of the pyramid, followed by theneed for safety, the need to belong, and theneed for status, while self-actualizationneeds are seen as the highest order ofneeds. These needs are met when aperson experiences a sense of personalgrowth and self-fulfillment by accomplishinga challenging goal.Finally, David McClelland proposes thatpeople have three basic needs, the need
  • 313. for achievement, the need for power, andthe need for affiliation. Whatever thetheory, managers must recognize theneeds of employees.Job DesignAnother way to understand and affectemployee motivation is to investigate theway a job is designed. Each job has certaincore job dimensions that describe theduties performed. These duties lead tocritical psychological states withinemployees that result in a variety ofoutcomes. Outcomes are the visiblemanifestations of work performance, whilepsychological states are hidden in thehearts and minds of people. If the humanelement is ignored, then quality andefficiency will suffer.
  • 314. If the MBA is confronted with a personnelproblem, it may be the result of job design.A close study of the core job dimensionscan often yield great benefits withoutsignificant costs. For example, at aLockheed parts factory in Los Angeles,unskilled minorities were hired and trainedto assemble parts for jumbo jets fabricatedat another factory. The employees wereunmotivated and the quality of their outputwas poor. In talking with the men workers,the managers realized that the work had nomeaning to them. They did not understandwhat they were producing. To fix that theworkers were taken to the aircraft assemblyplant to see where their parts wereinstalled. They also met those who wereinconvenienced when they received adefective product. Realizing the relevanceof their work, the employees became more
  • 315. productive and part defects decreased.Their previously pointless assembly taskacquired significance, and they respondedby performing better. The end result was ahappier work force that took pride in a jobwell done. The MBA term for suchemployee happiness is quality of work life(QWL). When employees are given thechance to be all that they can be, the wordMBAs use to describe this is empowerment. You can hardly pick up a business booktoday without tripping over that word.Job Design Model
  • 316. Adapted from “Introduction to Job Design,”by Professor William Zierden, Case UVA-OB-91R, Figure 1. Copyright © 1975 by theDarden Graduate Business SchoolFoundation, Charlottesville, Virginia.MBA Personality TraitsBusiness schools teach young women andmen business skills, but they also try to
  • 317. motivate their students to maximize theirown potential. In that vein, MBAs are taughtto be innovative leaders.Leadership. The top MBA schools claim tobe incubators for the business leaders oftomorrow. In this pursuit organizationalbehavior classes probe the subject ofleadership and its responsibilities. Someschools even send their students to thewoods for Outward Bound experiences tounleash the leaders inside them anddevelop team skills. Leaders shape goals.Leaders develop new ideas. Leaders reachpeople on an emotional level. Managers,on the other hand, react to events.Managers solve problems, while leaderstake on challenges. Of course, at the topbusiness schools, everyone fancies himselfor herself as a future captain of industry.
  • 318. The Leadership VCM Model. The VCMleadership model proposes that thefollowing three characteristics are part of aleader’s personal profile:- Vision- Commitment- Management SkillsLeaders exhibit these qualities in differingproportions. No particular mix works best. Itall depends on the individual and the jobsituation. Lee Iacocca could be viewed asbeing high on vision when he saw thepotential for the Ford Mustang in the 1960s.He also saw hope for Chrysler in its darkdays in the late 1970s. In the accountingprofession vision is not as critical, whereasmanagement skills and commitment to longhours are the keys to success.
  • 319. Leadership Patterns. There are as manyways to lead the troops as there arepeople. Leadership styles lie on a spectrumfrom boss-centered to subordinate-centered. In the 1960s executives raced tobe tested to see where they fell on thespectrum. Based on a managerial grid, theycould be classified a “dictator” or a “wimp.”Some bosses use their authority directly topress their people into action. They do thethinking, and the staff does the legwork.Others give their people the freedom to usetheir own wits to organize and accomplishtasks. The boss’s function is to give generaldirection.Leadership Styles Vision, Commitment,and Management
  • 320. Adapted from “Survey of Managerial Style,”by Professor James Clawson, Case UVA-OB-358, p. 14. Copyright © 1988 by theDarden Graduate Business SchoolFoundation, Charlottesville, Virginia.Which leadership style a leader chooses isregulated by three basic forces:- The forces within the manager- The forces within the subordinates- The forces of the situationIf the leaders do not have confidence intheir subordinates, they cannot delegate
  • 321. tasks. If a staff doesn’t have the ability towork unsupervised, full delegation ofauthority is inappropriate. When the staffhas a clear understanding of the businesssituation and how to address it, it’s best todelegate authority.It is very important for a leader tounderstand his or her own personalitytraits. As you might imagine, a leader’sinsecurities may lead to an authoritarianstyle, regardless of what the situation maydictate. That is why self-awareness isimportant; it will enable you to avoidinappropriate management styles.My faults and my virtues are thesame…Nothing is ever enough. I mustcheck everything. It causes meproblems—people think I don’t trustanyone. But I must know what’s going on.
  • 322. —Giorgio Armani, Forbes, October 28,1991Creativity. Not only are MBAs schooled tounderstand leadership, they are taught tobecome leaders by tapping their owncreativity. Because vision is an element inthe VCM pie, MBAs ought to nurture theirown creativity. Everyone has idea-friendlytimes when they are most creative. Forsome it may be while in the shower, forothers on the porcelain throne or in the car.Creative thought is often very fleeting; youmust be able to capture it in its tender,nascent stage. What a Great Idea by ChickThompson suggests that we should alwayskeep a pen, a tape recorder, or a greasepencil (for the shower) handy in each of ourfriendly places.
  • 323. The mind-mapping technique is alsoavailable. Take a blank piece of paper andstart thinking about a creative challenge,then write down the subject and circle it.Proceed, in a completely uninhibited style,to scribble and circle all your relatedthoughts around that subject’s key wordsand connect them like the spokes on awheel. Each of the spokes should havespokes around it, and so on. No thought istoo stupid! After it’s all done, somethingmay emerge from the jumble of freeassociation. I’ve used the technique to thinkup titles, promotional copy, and projectsolutions for this book. Try it—you havenothing to lose.An abbreviated mind-mapping session todevelop the name for this book looked likethe diagram at right.
  • 324. Type A and B Behaviors. OB professorshave introduced the concept of behaviortyping into the curriculum as an added toolfor personal understanding. Since mostMBAs attending the Top Ten schools wereadmitted because their Type Apersonalities helped them to the top of theircollege classes, it seems appropriate thatthey should understand that aspect ofthemselves. Type A behavior was originallyidentified in 1959 by two cardiologists,Meyer Friedman and Ray Roseman. Theynoticed that patients with severe coronaryheart disease were often characterized bythe following traits.Mind Mapping for a Book Title
  • 325. - A Competitive Need for Achievement- A Sense of Time Urgency- Aggressiveness- Hostility to Others and the WorldAdditional manifestations of Type Abehavior include explosive, acceleratedspeech, interruption of others, a fast-pacedapproach to life, and impatience. Type A’salways try to do more than one activity atonce. That’s what those Day-Timer plannerbooks are for. Type A’s are oftendissatisfied with life, showing a free-floatinghostility. They evaluate their self-worthbased on external achievements. One suresymptom is competition with others innoncompetitive situations. A classmatereported such a case: “During the interviewseason I was struck by a pizza companyexecutive who boasted that his
  • 326. performance on the treadmill, during thecompany’s annual physical, was superior tothat of his co-workers.” That executive wasa Type A.On the opposite side of the spectrum, thereare the Type B’s who enjoy life and aremore relaxed. Some Type B’s also sneakinto business schools. Most individuals fallin the continuum between the two poles.Hopefully, by recognizing the Type A signs,MBA hard chargers may be able to head offa heart attack by exercising some controlover their behavior. If not, behavior typingcan make good bar conversation for MBAsheading for coronary oblivion.MBA Office ProceduresThe OB faculty, besides making studentsaware of their potential and shortcomings,tried to teach us some practical
  • 327. interpersonal skills that would help us tosucceed on the job.Active Listening. One of the most valuableskills is to be able to really listen. Activelistening helps you to gain a clearperception of situations so that you caneffectively deal with them. It differs fromconversation in three ways:- You Respond to Information and Don’t Lead.- You Respond to Personal Information and Don’t Give Advice.- You Identify the Interviewee’s Feelings as Well as the Content.An active listener cedes control of theconversation to the other party. Givenenough leeway, true motivations, feelings,and beliefs can come forth. After the active
  • 328. listening session runs its course, you canstart to talk and act like an MBA know-it-allagain.Performance Appraisals. One of the mostmismanaged tools for organizationalimprovement is the performance appraisal.Rating forms are sometimes used veryeffectively for timely feedback and personaldevelopment. However, most of the time itis a task that is delayed until the appraisalreally has lost all usefulness. Effectiveappraisals ought to have three types ofgoals:OrganizationalFeedback and EvaluationCoaching and Development
  • 329. Organizational goals aim to ensure properconduct and levels of performance,placement, promotion, and pay. Thefeedback and evaluation aspects provideboth employees and employers with aformal process and documentation ofperformance. Coaching and developmentshould ultimately be the primary goals of anappraisal. How can we improve, rather thanpunish, unsatisfactory performance?Working together, the boss and thesubordinate should agree on specifictargets and timetables for improvement.These plans for the future lay thegroundwork for a follow-up.The problem is that managers tend to avoidthis evaluation process. Subordinates aredefensive. The appraisal must be timely;
  • 330. both participants must be prepared. Theboss should foster an open climate of realcommunication (both ways) and make thepurpose of the appraisal clear. As simpleas the appraisal can be, it is seldom doneright.In addition to the potential for improvement,appraisals provide employers thedocumentation to legally fire an employee.Without documentation a disgruntledworker could sue the company for lack ofjust cause.Reprimands. Sometimes an MBA will becalled on to lower the boom. In line with myclass discussions, the MBA shouldreprimand a subordinate using the followingfour steps.
  • 331. 1.Check out the facts first. Ask yourself if you caused the problem.2.Give warning that you need to talk about the problem.3.Pause and express your displeasure. Tell it exactly as you see it. Yelling is counterproductive.4.Display a caring attitude. “I did not approve of your behavior, but you are still okay.” “Let’s learn from this and put it behind us.” The idea is to do it firmly, clearly, and move on to new business.“A good manager can balance hisreprimands with praise.”Managing Your Boss. MBAs are not alwaysbosses. Most start out as lowly analysts,planners, and associates. Ironically, these
  • 332. are the positions that operations classescharacterize as corporate fat, ripe fortrimming. Even if MBAs find themselves inmore senior managerial jobs, it’s a safe betthat they will have a boss to deal with. Evenpresidents have to deal with chairmen!Management of the relationship upward isas important as managing your relationshipbelow. That’s why I’ve included it in thisbook. To give the MBA an edge, thecurriculum includes a session on how tomanage your boss. “Managing Your Boss”appeared in the Harvard Business Reviewin January 1980. It was written by JohnGabarro and John Kotter and it capturesthe subject well.“The first step to success on the job is tounderstand bosses and their context,including:
  • 333. - Their stated and unstated goals and objectives- The pressures on them- Their strengths, weaknesses, blind spots- Their preferred work styles“The second step is to be introspective andassess yourself and your needs, including:- Your own strengths and weaknesses- Your personal style- Your predisposition toward dependence on or resistance to authority figures“The third step is to incorporate the first twosteps and develop and maintain arelationship that:- Fits both your needs and styles- Is characterized by mutual expectations- Keeps your boss informed—bosses hate surprises!
  • 334. - Is based on dependability and honesty- Selectively uses your boss’s time and resources” *Simply by asking a few questions at thestart of the relationship, you can avoidmaking major political blunders in thefuture. Some bosses like a formalrelationship, memos, and meetings withagendas. Others prefer informal notes andfrequent unstructured meetings. SmartMBAs take the initiative to ask their bosseshow they would prefer to communicaterather than guess. Careers often hang inthe balance. I still keep Gabarro andKotter’s article at my desk as a reminder tomanage my boss.Understanding Power on the Job. If MBAswant power, then they ought to know more
  • 335. about what they seek. There are actuallyfive types of power:CoerciveRewardReferentLegitimateExpertCoercive power is based on fear. Failure tocomply with a request could result in someform of punishment. A person with coercivepower can influence or directly fire, demote,or transfer an employee. At a firehouse, thechief has the power to assign shifts. If youget on the chief’s bad side, it could meanyou work holidays.
  • 336. Reward power is based upon theexpectation of receiving praise, recognition,or income. It’s the opposite of coercivepower.Referent power is derived from being aperson whom other people admireregardless of formal job status. Thesepeople are said to have charisma to inspireand to attract followers. Star salespeoplehave this role in sales organizations.Legitimate power is due to the formal statusheld in the organizational hierarchy. Thosewith this type of power can use it to reward,to ax, and to influence the lives of others inthe organization. A shift foreman has thepower to assign duties on an assembly line.Expert power comes from one’s own skill,knowledge, or experience. People withexpert power have the ability to manipulate
  • 337. others. This is without regard to theirposition in the company. Often it is a lowlycomputer technician who may have thepower to bring a senior executive to hiscubbyhole. The boss must crawl forassistance. Crafty technicians fix it so thatthey alone have the ability to tap into thedatabase. This preserves their expertpower. It’s a manager’s job to cross-trainpeople to prevent the birth of such littlegenerals in their organizations.In the political gamesmanship ofcorporations, it is important for MBAs torecognize all the people in the organizationwith the power to influence their lives.MBO and MBWA. MBO and MBWA arefrequently used abbreviations in MBAbabble. MBO means management by
  • 338. objective. It is a management stylepopularized by management guru PeterDrucker in the 1950s. Bosses delegatetasks by “negotiating a contract of goals”with their subordinates without dictating adetailed road map for implementation. MBOmanagers focus on the result, not theactivity. At Frito-Lay, for example, a vice-president might set a sales target for herregional sales managers. The managersdecide what tactics and strategy areneeded to meet the objective.The MBO style is appropriate when yourstaff is competent. Chief executives ofmultinational corporations (MNCs) useMBO for their country managers abroad.Their bosses in the United States oftenhave little knowledge of what is required forsuccess in those international markets.
  • 339. MBO is appropriate in situations where youwish to build employees’ managementskills and tap their creativity and initiative.The drawback to MBO is the time neededto adequately negotiate and document theprocess. Therefore, MBO should be used inappropriate situations.MBWA, management by walking around,was a theory expounded at Hewlett-Packard, the computer giant. HPexecutives were encouraged to be out oftheir offices working on buildingrelationships, motivating, and keeping indirect touch with the activities of thecompany. MBWA is a simple concept, but ithas become part of an MBA’s portfolio ofmanagement theories. Organizational Level Topics
  • 340. With a psychology lesson and a set of MBAoffice procedures to work with, the OBcourses take a “bigger picture” look atorganizations. With a larger scope alsocome grander theories and the vocabularyto accompany them.The Basic Organization Model
  • 341. The Basic Organizational ModelTo understand an organization, you have toconsider all of its components.Organizations are networks of related
  • 342. parts. Each element works together tosupport efficient operations. The new MBAbuzzword for it all is organizationalarchitecture.A noteworthy feature of the diagram is thatthe individual is at the center. The reasonfor this is that organizations are made notof brick and mortar but of people.Organizations affect those individuals. Thetheories in the previous sections focusedon the individual. In the following sectionsthe macro-view of the organization isexplored in MBA terms.As shown in the diagram, there are sixelements that define organizations. Someare self-explanatory, but others havespecial MBA significance that you shouldbe aware of.
  • 343. Strategy. Strategy describes an explicit orimplicit plan for success in the marketplace.When an airline decides to lure customerswith either lower prices or better service,that is a corporate strategy. (Later in thebook, I devote an entire chapter to this trulyMBA topic.)Policies and Procedures. Policies areformal rules that, in all but smallcompanies, are captured in a handbook,while procedures are the observable waysin which a company conducts business.Vacation and benefits are policies that arecodified. Routine tasks such as how wastepaper should be separated for recyclingmay not be committed to paper. It’s aprocedure that is understood.
  • 344. Organizational Structures. Structurevocabulary is a lexicon that no MBA can bewithout. It is a frequent subject ofdiscussion in corporate meetings and isalso an important tool for managingorganizational behavior. Structuresdescribe the hierarchy of authority andaccountability in an organization. These“formal” relationships are frequentlydiagrammed in organization charts. Mostcompanies use some mix of structures toaccomplish their goals. People who aredirectly involved in producing or marketingthe firm’s products or services are calledline employees. The others who advise,serve, and support the line are called staffemployees. Line and staff employees canbe organized along the following lines:
  • 345. FunctionalProductCustomerGeographicDivisionalMatrixAmorphousFunctional. The functional form divideswork by tasks, e.g., advertising, accounting,finance, and sales. These departmentsreport to the senior executives.
  • 346. “Organizational Structure,” written byProfessor James Clawson, Case UVA-OB-361, Figures 1–8. Copyright © 1988 by theDarden Graduate Business SchoolFoundation, Charlottesville, Virginia.Product. The product structure groups allfunctions necessary to deliver a specificproduct. Product managers manageindividual products as smaller businesseswithin a company. Black & Decker, forexample, is divided into separate units
  • 347. responsible for power tools, smallappliances, and accessories (see top chart,right).Customer. The customer structure focuseson—you guessed it—the customer.Activities, such as production andmarketing, are grouped with other functionsto satisfy specific customer needs. Thecustomer structure is common in serviceindustries. Banks often divide responsibilityby customer type. For instance, some loanofficers are trained to serve businessclients, others to serve individuals. Eachhas “expert” knowledge to deal with his orher customers’ specific needs (see bottomchart, right).Geographic. In this arrangement work isdivided by location. Geographic structurescut across customers and products.
  • 348. Regional offices are established to managethe business. This is especially true ofinternational businesses, where eachcountry’s office would adopt its ownstructure.
  • 349. Divisional. Divisions are independentbusinesses operating under the umbrella ofa parent corporation. Unlike the previousfour structures, divisions run somewhatautonomously. They do it all themselves,from marketing to buying raw materials.However, most divisions use the parentcompany for financing. For example, the
  • 350. Philip Morris Companies includes MillerBrewing, Kraft Foods, and Philip MorrisTobacco. These three businesses arecentrally owned but separately operated.Within each of the divisions there may beother organizational substructures. Forexample, Miller may use the geographicform and Kraft Foods may use a productstructure (see chart, right).Matrix. The matrix structure departs fromthe principle of unity of command: only oneboss for each employee. Here there aretwo or more lines of authority. The matrix iscommon in businesses involved in large,complex projects that require highlyspecialized skills. In this structure, both theproduct and the functional structurescoexist. Employees report to both a projectmanager in charge of their assigned
  • 351. product and a functional manager whocontrols specific activities such asmanufacturing, finance, and marketing. Asyou might expect, this organizational formcan be confusing. It requires a staff that isflexible and professional. The defense andcomputer industries often opt for the matrixstructure to handle large developmentprojects (see top chart, page 132).
  • 352. Amorphous. This is my personal favorite.The amorphous structure is no formalstructure at all. It’s the free bird. In thesecompanies highly motivated and productivemanagers create and dissolve reportingrelationships as the task at hand requires.In these companies, the structureincrementally grows as events dictate.Digital Equipment Corporation is said tohave grown with an amorphous structure(see bottom chart, page 132).Hybrid. These entities are composed of amix of operational structures. Mostcompanies fall into this category. GeneralElectric has a divisional corporate structurethat includes the NBC television network,GE Lighting, GE Capital, and GEAerospace. But within each division, thereare geographic manufacturing
  • 353. organizations, matrix research staffs, andcustomer sales grouped organizations. Inthe example above a single business isorganized in a functional/product hybrid.The brand managers control their productsand marketing, but they do not havecomplete control over the financing oroperations of the business.
  • 354. The choice of structure dramatically affectsthe operations of a company. There needsto be a fit between the business activitiesrequired and the corporate apparatus setup to produce and deliver the service.
  • 355. Managers should select a structure thatreflects their goals and strategy. Thestructure that is set up enables individualsto interact in ways that will best achievegoals. Informal reporting relationships formspontaneously and these fail to berepresented in the organizational chartskept by the personnel department.Recognizing both the formal and informalstructures is crucial in executing asuccessful action plan.An important issue related to reportingrelationships is the span of control. Thespan describes the number of people whoreport to a manager. During restructuring,downsizing, and recessions this topicbecomes popular. Using a decreased spanof control, large corporations often firemiddle-manager MBAs. The remaining
  • 356. managers have more staff. If a salesorganization changes from a policy of oneregional manager for every three regions toone for every four, that displaces 25percent of the regional managers. MBAscall these layoffs a reduction in force (RIF),demassing, or restructuring. It’s a nice,antiseptic way for managers to describe thefiring of many people. Span-of-controlpolicies are powerful organizational tools.
  • 357. Systems. Each organization developssystems for allocating, controlling, andmonitoring money, things, and people.
  • 358. Systems also perform informationalactivities by gathering information andchanneling it to interested users. Systemsfall into one of six categories:Money Allocation, Control, and Monitoring—Accounting, investment, and budgetingsystemsObject Allocation, Control, and Monitoring—Inventory and production systemsPeople Allocation, Control, and Monitoring—Human resource planning, employeedata and appraisalsFuture Anticipation—Strategic planning,marketing-sales planning, businessdevelopment functionsPeople Reward and Incentives—Compensation schemes, bonus plans,
  • 359. profit-sharing plansIntegrative—Mixes of the first five. In well-managed companies, integrated systemsforecast sales, which in turn dictatesproduction schedules required to meet thatneed.It is crucial to understand the systems of anorganization, because they are the tools forchange. Systems provide both a meansand, at times, a barrier to corporatechange.Climate. This is a nebulous term that refersto the emotional state of an organization’smembers. Many companies hire expensiveconsultants to perform satisfaction studiesto determine the “climate” of theirorganization so that improvements can bemade. In service industries where people
  • 360. are the most valuable assets, such as lawfirms, investment banking houses, andconsulting practices, the climate of the firmplays an important role in determiningservice quality.Culture. This is another hazy term. Cultureis the mix of behaviors, thoughts, beliefs,symbols, and artifacts that are conveyed topeople throughout an organization overtime. It may extend to such silly things asan unwritten rule that all men must wearwhite pinpoint oxford shirts or corporatelapel pins. Culture may include a beliefabout desired employee conduct. “Seniorexecutives must always work past sixo’clock.” “It’s important to look busy at alltimes.” A main criterion for recruiting isoften the perceived “fit” of interviewees with
  • 361. the organization. If a person does notappear to “fit” into the corporate culture,then he or she in many recruiters’ eyesprobably will not be an effective employee.The six elements of an organization(strategy, policies, structure, systems,climate, and culture) dynamically affect oneanother. Each element interacts with theenvironment as a business strives towardits goals. The problem definition/actionplanning process requires that a managerlook at all six elements of the organizationmodel to determine which action levers willexist to implement positive change. If theenvironment changes, the organizationalelements must adapt. MBAs like to refer tocompanies that can change as learningorganizations.
  • 362. Organizations that are stuck in the sameold pattern of thinking and acting are saidto be trapped by their paradigms or mind-set. High-priced consultants often counselstagnant companies on how to break theirold paradigms so that they can change andsucceed. Use the word paradigm severaltimes in a conversation tomorrow, andyou’re one step closer to becoming a Ten-Day MBA.The Human Talent Flow PyramidThe structure of a firm dictates not onlyhow employees are grouped but also howthey can advance in a firm. At eachprogressive stage the individual assumesmore authority. People either leave, getfired, or are promoted. A handy MBA tool totrack this flow of human capital is a pyramiddiagram.
  • 363. By tracking the flows of people in and out ofan organization, we can clearly identifyturnover problems, skill deficiencies, andentrenched management. The diagramhelps to point out graphically the “leakages”and “blockages” of people flows within theorganization. Employees enter all levels ofthe organization as depicted at the left andmove up within the pyramid. If there is littlemovement from one level to another, thisblockage may cause many people tobecome frustrated and leave to the right ofthe pyramid, a leakage. Discriminationissues such as “glass ceilings” for womenand minority promotions can be analyzedusing this pictorial technique.The Human Talent Flow Pyramid
  • 364. Systems Theory and OrganizationalAnalysisSystems theory is a concept that likensorganizations to living organisms. Just asanimals have their endocrine, digestive,and nervous systems, academics proposethat organizational bodies have similarsubsystems that enable them to live. Whendiagrammed, an organization looks like aparamecium.
  • 365. The management subsystem is the organthat sets the goals, plans, and controls,similar to the brain. This is the role ofexecutives.The adaptive subsystem acts as a firm’seyes to monitor the environment. Thesystem also makes sure that the firm’sproducts and services are appropriate in achanging environment to ensure survival.Information gathered from marketresearchers, customer servicerepresentatives, and salespeople makes acompany adaptive.The boundary spanning in subsystem is themouth. It controls the intake of theorganization’s food. In a company, thissubsystem includes recruiting people,buying raw materials, and raising money.
  • 366. The bowels of the company are theproduction subsystems. It converts theinputs into goods and services. In amanufacturing company, these are thefactories.The bowels lead to the boundary spanningout subsystem. The marketing crew helpsthe company produce its products andservices. The personnel department dealswith the outplacement of employees whohave not met company standards. Andfinally, the public relations department triesto put a good face on the company’sactions.Systems Theory
  • 367. “Systems Theory and OrganizationalAnalysis,” by Professor James Clawson,Case UVA-OB-214, Figure 1. Copyright ©1983 by the Darden Graduate BusinessSchool Foundation, Charlottesville, Virginia.
  • 368. Once the animal is breathing andfunctioning properly, the maintenancesubsystem tries to keep the othersubsystems working efficiently together.This cerebellum maintains a balance in theorganization by coordinating all themovements of the body. Examples of themaintenance subsystems include employeeincentives and company newsletters.Systems theory provides yet another wayof analyzing an organization to gauge itshealth or to make a change in its life-style.Evolution and Revolution of Organizations
  • 369. Reprinted by permission of HarvardBusiness Review. An exhibit from“Evolution and Revolution as OrganizationsGros” by Larry E. Greiner, Volume 50,Number 4 (July/August 1972). Copyright ©
  • 370. 1972 by the President and Fellows ofHarvard College; all rights reserved.Evolution and Revolution as OrganizationsGrowLarry E. Greiner of the Harvard BusinessSchool wrote a noteworthy article with thistitle in the Harvard Business Review in July1972, describing the growing pains thatorganizations go through.Greiner proposed that organizations exhibitfive predictable stages of growth calledevolutions and five periods of crises calledrevolutions. His theory is readily applicableto many organizations. The growth patternconsists of tightening and loosening ofmanagement reins in response to changeswithin the organization and theenvironment.
  • 371. The evolution/revolution pattern, as shownby Apple Computer, is an excellent way toput a company’s history into MBAperspective. Apple Computer sprang forthfrom the creativity of Steven Jobs andStephen Wozniak. Beginning in 1976,these two entrepreneurs were on a freighttrain of rapid growth until the companybecame so unwieldy that is almost jumpedthe tracks in 1983. Apple was faced withthe leadership crisis of a growth companythat didn’t have anyone who couldefficiently run its day-to-day operations.Jobs was a lofty visionary makingspeeches, while Wozniak was the magictechnician.The company started to run out of gas asits creative fuel ran low. Apple II salesslumped and the new Lisa computer failed.
  • 372. John Sculley (Wharton MBA ’63) wasbrought in from Pepsi-Cola to give thecompany direction. Sculley reorganizedApple and cut costs in its bloatedheadquarters. Steve Jobs and his followersdemanded more autonomy to develop anew breakthrough product and Sculleygave it to them. The delegation resulted inthe creation of the Macintosh.The Mac created another explosive growthperiod. However, Jobs could not work in agrowing corporate bureaucracy, and hestarted a new company called NeXT. In1989 the aging Mac faced fiercecompetition, and as profits declined in1990, a new Apple crisis of control wasbrewing. Michael Spindler was appointedas chief operating officer to assist Sculleyas chairman to take control and return the
  • 373. company to increasing profitability. By 1992they had succeeded, but fell into crisis in1995. Steve Jobs returned and led yetanother recovery in 1998 with the iMac andG3 computers.Choosing Strategies for ChangeIn addition to all the theory about the mindand corporate body, MBAs receive practicalguidance for taking action in difficultsituations. Even if an action plan is“perfect,” there is always resistance tochange. Even those well-thought-out planssuch as the one the new MBA proposed tohis boss at the beginning of this chaptermay run up against a wall. Fortunately,John P. Kotter and Leonard A. Schlesingerformulated a tidy model to assist MBAs intheir article “Choosing Strategies forChange” in the Harvard Business Review
  • 374. of March 1979. The appropriate course ofaction all depends on the situation.Situation Action Needed for ChangeCompany Lacks Information Educationand Communication TacticsIn a stodgily run manufacturing company inSalt Lake City, the employees were kept inthe dark about corporate profitability.Judging by the expensive cars of theowner, they assumed that all was well.Unfortunately, the company was losingmoney and layoffs would be inevitableunless productivity rose. In this situation,the employees would need to be informedabout the true condition of the companybefore they gave their full cooperation towork more efficiently.
  • 375. You Need Information and You Have LittleLeverage Participation and InvolvementTacticsA metal fabrication plant in Kansas Cityhired a consultant to cure absenteeism.The consultant did not know the people, thepersonalities, or the town. Because shewas an outsider, she had no power todemand cooperation for her investigation.She first had to gain the trust of the workersand begin to talk with them about theproblems that prompted so many sick days.She needed their cooperation andinvolvement to define and solve a problemfor the workers as well as for management.Adjustment Problems Support andFacilitation TacticsAs offices become computerized across thecountry, secretarial work has changed.
  • 376. There are no more typewriters. Secretariesare required to use word processorprograms on computers. Instead of hiringnew help, companies need to retrain theirstaffs. Companies must hire computersupport staff to help with this adjustment.Your Desired Changes Will Cause Lossesand Opponents Have Power to Block YouNegotiation and Agreement TacticsIn the 1980s robotics were introduced inthe American auto industry. Japaneseimports were taking jobs overseas. GM,Ford, and Chrysler chose to negotiate newagreements with the powerful United AutoWorkers union to allow work-rule changesrequired by the new technology. If thecorporations had decided to play hardballand impose their will upon the UAW, theunion could have struck, and both parties
  • 377. would have ended up losing. Bycooperating both had a chance of surviving.You Have No Alternatives and No Moneyfor Facilitation Manipulation (Give NoChoices)In distressed companies there are often noalternatives to layoffs and wage cuts. Amanufacturer of electronic switches inTrenton, New Jersey, gave its employeesthe choice of lower wages or no jobs at all.They took the pay cut, but the companyfailed anyway.Frank Lorenzo of Texas Airlines, in hisleveraged buyout of Eastern Airlines,saddled the air carrier with a huge debt. Asa result he obligated the company to makehuge interest payments. To salvage thesituation, Lorenzo demanded across-the-board pay cuts, but he underestimated the
  • 378. union’s resolve to resist his demands. In1990 Eastern ceased operations.Speed Is Needed and You Have the PowerExplicit Orders and Coercion TacticsThis situation is most common in theconsulting, law, and public accountingprofessions. The familiar scene begins witha client requesting a project due“yesterday.” The partner calls in a lowlyassociate and demands that theassignment be completed “the day beforeyesterday.” The partner says jump and theassociate jumps. The partners hold thepower. The rub is that employees burn outand leave. Fortunately for the firms, thereare legions of eager college graduates toreplace their ranks. If you choose coerciontactics, you have to be sure you have thepower and are willing to deal with the
  • 379. consequences.An Overview of Organizational BehaviorAbove all, MBAs should think before theyact. When MBAs need to take action theyshould thoroughly analyze the situation,first from the perspective of the individualand then from an organizational vantagepoint, to create a coordinated and effectiveaction plan. MBAs are not trained to be“organizational experts” by any means, butwith a few theories and frameworks, theyshould have a better chance of actingeffectively. Key OB TakeawaysWant Got Gaps—Organizational problems
  • 380. Causal Chains—The relationship ofproblems to one anotherAction Planning—A specific series ofactivities to solve an organizational problemAPCFB Model—A human psychologymodelGoal Congruence—People with similargoals work better together.Expectancy Theory—Motivation is afunction of how an employee’s actionstranslate into a reward.VCM Leadership Modely—The vision,commitment, and management aspects ofleadershipActive Listening—Listening to gain insightThe 5 Forms of Power—Power is derivedfrom more than a title.
  • 381. The Basic Organizational Model—Strategy, policies, structure, systems,climate, and cultureStructure—The way a company organizesitselfSpan of Control—The number of people amanager directly controlsParadigm—A corporate mind-set or patternof doing thingsSystems Theory—An organizationfunctions much like a body.The Evolution and Revolution Pattern—Organizations go through a series ofgrowth and crisis periods during theirlifetimes.*Reprinted by permission of HarvardBusiness Review, “Managing Your Boss”by John J. Gabarro and John P. Kotter
  • 382. (Jan./Feb. 1980). Copyright © 1979 by thePresident and Fellows of Harvard College;all rights reserved. Day 5 QuantitativeAnalysis Quantitative Analysis TopicsDecision Tree AnalysisCash Flow AnalysisNet Present ValueProbability TheoryRegression Analysis and ForecastingQuantitative analysis (QA) is probably themost challenging and most importantcourse in the MBA curriculum. It provides
  • 383. the basic tools principally used in finance,accounting, marketing, and operations.Therefore, these pages are not to beskipped over simply because you are notaccustomed to dealing with numbers andstatistics. Give it a chance!Quantitative techniques provide MBAs witha way to distinguish themselves from theirnon-MBA peers. MBAs can make a splashwith their bosses by creating sophisticatedcharts and graphs and by using impressivelanguage. Hopefully, the conclusions theyhave to deliver are a welcomed story.Using QA theories to solve businessproblems is the MBA’s main job.Quantitative analysis helps MBAs remainobjective when solving complicatedproblems. The theories behind thetechniques are inconsequential. Their
  • 384. application to solve real business problemsis what is important. Yet it should be notedthat no matter how mathematically precisethe tools of quantitative may appear, theyare no substitute for an MBA’s own bestjudgment.
  • 385. Decision TheoryDecision theory teaches how to breakcomplex problems into manageable parts.Without a framework to attack difficultsituations, such cases quickly becomeunmanageable. For example, QA can beused to help a wildcatter decide whether ornot to drill for oil. The inherent risks of oilexploration, however, cannot be eliminated.A decision tree diagram can organize theproblem’s alternatives, risks, anduncertainty.Decision tree analysis consists of thefollowing five steps:1.Determine all the possible alternatives and risks associated with the situation.2.Calculate the monetary consequences of each of the alternatives.
  • 386. 3.Determine the uncertainty associated with each alternative.4.Combine the first three steps into a tree diagram.5.Determine the best alternative and consider the nonmonetary aspects of the problem.Decision tree diagrams include activityforks and event forks at the juncture wheredifferent alternatives are possible. Forexample, the decision whether to drill for oilor not represents an activity fork in the treefor an oil wildcatter. It is symbolized on adecision tree by a square. If the differentalternatives are subject to uncertainty, thatis an event fork. The uncertain outcome ofa well producing oil would be considered anevent. It is symbolized on a decision tree bya circle.
  • 387. Decision Tree ExampleAs an illustration of a situation where thedecision tree could be helpful, consider Mr.Sam Houston of Texas. Mr. Houston isabout to exercise his option to drill for oil ona promising parcel. Should he drill? If hehits a gusher there is an estimated$1,000,000 to be gained. When heinvestigated all of the alternatives, Mr.Houston made the following list:
  • 388. 1.Sam paid $20,000 for the drilling option.2.Sam could lower his risks if he hired a geologist to perform seismic testing ($50,000). That would give him a better indication of success and lower his risk of wasting drilling costs.3.Should he roll the dice and incur $200,000 in drilling costs without a seismic evaluation to guide him?4.Sam consulted with oil experts. They believe Sam’s parcel has a 60 percent chance of having oil without the benefit of any tests.5.It has also been the experts’ experience that if seismic tests are positive for the oil, there is a 90 percent chance there is “some” oil. And conversely, there is a 10 percent chance of failure.
  • 389. 6.If the seismic tests are negative, Sam could still drill but with a 10 percent chance of success and a 90 percent chance of failure.7.Sam could decide not to drill at all.Each piece of information above isincorporated into a tree diagram. A treediagram graphically organizes Mr.Houston’s alternatives.Before you get too enthusiastic over thedrawing of trees you must determine whatinformation is irrelevant. In this case, the$20,000 Sam paid for his drilling option isextraneous; it is a sunk cost. The money isout the door, sunk down a well. It isn’tcoming back no matter what Sam decides.Sunk costs are therefore excluded fromdecision trees.
  • 390. Drawing a Decision TreeThe first step to drawing the tree is todetermine the first decision (or fork of thetree) that needs to be made. Should Samchoose to test first? If seismic testing ischosen, it would precede all of the other
  • 391. activities that follow. It is reflected in thetree as a square at the first fork.If Sam tests, it could result in a positiveevent (60 percent chance) or negativeevent (40 percent). If there are no tests, hecan still choose to drill or not (square).Regardless of the results of the seismicreport, Sam can still “choose” to drill or not.But once the oil rig is drilling, the existenceof oil is an uncontrollable event. Eitherthere will be a lucrative oil event or not.
  • 392. The next step is to add the monetaryconsequences—they are like the “leaves toa tree.” If there is oil, there would be a$1,000,000 payday. Drilling costs are$200,000 per well. Testing costs are$50,000 per well.To know the potential financial outcomes ofeach decision, multiply the possible dollaroutcomes by their probabilities at forks
  • 393. where there is an “event circle.”([$1,000,000 payday × .90 probability] + [$0payday × .10 probability] = $900,000). Thisgives you the expected monetary value(EMV) of the event, although the actualindividual outcomes can be a range ofvalues. At any circle, the probabilities mustadd up to 100 percent (.90 + .10 = 1.00) todenote that all possibilities are accountedfor. Each fork is mutually exclusive of otheralternatives and within that alternative theprobability is 100 percent or collectivelyexhaustive.At activity squares the decision maker hasthe ability to choose the best outcome. Todetermine the best alternative, subtract theapplicable cost from the payoff of thealternative. You calculate the monetaryconsequences by beginning at the far right
  • 394. and working your way to the left. Thisprocess is said to be “folding back” or“pruning” the tree to arrive at your bestaction plan decision. At square forks youshould choose the highest dollaralternative. At the circle multiply thepossible payoffs by their probabilities.The Decision Tree Oil Drilling
  • 395. The decision dictated by the tree is to throwcaution to the wind and forgo the seismictests. The expected monetary value ofgoing ahead with testing is $370,000(420–50), while the EMV of going ahead
  • 396. without tests is $400,000. You choose thehighest expected monetary value (EMV).This relatively simple conceptual frameworkcan be applied to new productdevelopment, real estate development, andstore inventory level decisions. Whateverthe decision to be considered, a decisiontree structure forces the decision maker totake a comprehensive view of all thealternatives, to make an evaluation of theuncertainty (you often have to make yourbest guess about probabilities), and toexplicitly calculate the dollar outcomespossible. The tree forces decision makersto state their assumptions explicitly. Otherslooking at the same situation could see itotherwise. By comparing trees, analystscan debate specific assumptions in anorganized way.
  • 397. “Draw a tree and get a B” was the sayingon exams involving decision trees. Thecomplexity of seemingly simple problemscan be seen using decision trees.Therefore, just creating an accurate treeframework was a challenge during a four-hour exam; it takes a lot of practice tobecome proficient.The Decision TreeOil Drilling(in thousands of dollars)
  • 398. Cash Flow AnalysisThe team cash flow is often used inconnection with leveraged buyouts (LBOs)
  • 399. of companies on Wall Street. It is the basisof financial analysis. Wall Streettechnicians may ponder briefly thequalitative aspects of their investmentdecisions, but ultimately, only the cashconsequences have any real relevance forthem. Cash flow analysis is based on thesame information used by the accountant’sStatement of Cash Flows. Cash flowanalysis answers the simple question:What does the investment cost and howmuch cash will it generate each year?The cash generated by a company can beused to pay off debt, pay dividends, investin research, purchase new equipment, orinvest in a real estate development. Thegoal is to determine when and how muchcash flows in a given case scenario.
  • 400. In making an investment there may beseveral objectives in mind, but cash flowanalysis concerns itself only with thedollars. A company’s advertising maycreate goodwill with the public, for example,but if the benefits cannot be measured indollars, cash flow analysis is notappropriate.Cash flow analysis is as relevant to thepurchase of a piece of machinery as it is tothe acquisition of a corporation. So let usrestate the first question asked:What is the current investment and whatare the future benefits?The steps to answer the questions are:1.Define the value of the investment
  • 401. 2.Calculate the magnitude of the benefits3.Determine the timing of the benefits4.Quantify the uncertainty of the benefits5.Do the benefits justify the wait?One important issue to consider is thatcash flow analysis indicates cash flows, notprofits. For example, a successful computerstart-up company in Silicon Valley may bemaking an “accounting” profit of $3 million.But if the company requires a $20 millioninvestment in research and a $30 millionoutlay to build a factory, the company isactually a net user of cash. In this case thecompany’s profitability lies in the future.Accounting profits, as reported in theincome statement, are a short-termmeasurement of an investment in a timeframe shorter than the life of theinvestment, whereas cash flow analysis is a
  • 402. technique used to evaluate individualprojects over the life of the project.The following specific information would berequired to quantify the initial cash flows ofa project:Cash Uses-Construction Costs-Initial Inventory Stock-Equipment Purchases-Increases in Accounts Receivable (allowing customers to borrow form you for goods sold to them)Cash Sources- Sales of Equipment (if disposed of)- Increases in Accounts Payable (borrowing from suppliers on materials purchased)
  • 403. To determine the cash uses during the lifeof the project:Cash Sources- Revenues or Sales- RoyaltiesCash Uses- Costs of Goods Sold- Selling Costs- General and Administrative Costs- TaxesDepreciation, which appears in incomestatements, is not relevant in cash flowanalysis. Depreciation is an accountingallowance that says that if a piece ofequipment has a useful life of five years,then one fifth of the cost in each year ofuse can be deducted from income. In a
  • 404. cash flow analysis, hard cash is used tobuy the machine today, therefore it isshown as a use of cash at the time ofpurchase. Depreciation is only applicableinasmuch as it is used to reduce“accounting income,” thereby reducing the“cash” out the door for taxes. In the Bob’sMarket example in the accounting chapter,the store expensed its cash registers andshopping carts over a ten-year period eventhough they were paid for at the store’sopening.A second important point is that financingcosts are not included in cash flowanalysis. The investment decision isseparate from the financing decision. AtGeneral Electric there are thousands ofprojects and many classes offinancing—debt (bonds, bank debt) and
  • 405. stock. To match debt with individualprojects would be impossible. In reality, thefinance department borrows to meet all ofits current corporate needs and it is thecapital budgeting department that decideswhich projects to adopt. If the two decisionswere linked, all projects that were financedby debt would look much better than thosefor which cash is paid up front, even thoughin substance they are the same.A Cash Flow ExampleQuaker Oats is considering a $100,000investment in a cereal filling machine for itsplant in Kansas City. The fiber craze hasspurred the demand for oatmeal to thepoint of exhausting plant capacity. If themachine is purchased, additional cerealsales of $80,000 could be made each year.The cost of goods sold is only $20,000 and
  • 406. the profits derived would be taxed at 30percent. The increased sales will alsorequire holding $10,000 in inventory.Quaker will partially offset that use of cashby increasing its payables by $8,000 tofarmers for the oats and Stone Containerfor the boxes to net a $2,000 additionalcash investment.At the end of three years the machine willbe worn out, but the equipment will still beuseful to a milling company in Mexico.Quaker plans to sell it to Molino Grande ata price of $10,000.The Timing of Cash Flows Quaker OatsFilling Machine Project(in thousands of dollars)
  • 407. In this example the timing of cash flows iscritical to determining the project’s value. Acommonly used representation of thetiming of cash flows is a bar graph. Each
  • 408. period, cumulative cash flow is reflectedeither below the line for cash investmentsor above the line for returns. Our Quakerexample is shown in the following bargraph:Suppose that the cash flows are the samebut the timing of the cash is advanced asfollows:
  • 409. or prolonged as follows:
  • 410. These diagrams raise the critical issue ofthe “value” of timing.Accumulated Value Calculation
  • 411. Accumulated ValueWhen the milling project produces cash,Quaker reinvests it rather than let it remainidle. Therefore if Quaker receives $51,000,$51,000, and $61,000 as described earlier,the company earns income with the cashfor two more years in Scenario A than inScenario B.If the company has investmentopportunities that yield 10 percent, thenScenario A will produce $34,230 more thanScenario B.The flows have an accumulated value atthe end of three years of $163,000 plusearned interest of $34,230 that equals$197,000. Scenario A is clearly the betterscenario.A simpler calculation is to use the formulafor the accumulated value or future value of
  • 412. a dollar:Future Value of a $ in x periods = ($ today)× (1 + Reinvestment Rate) Number ofPeriodsAt 10% the factor for 1 year = $1 × (1 + .10)1 = 1.10.You don’t have to memorize the factors orcalculate them each time—you can use thetables provided in the Appendix, or anybasic business calculator. (The bestcalculator in my opinion is the Hewlett-Packard 17B. Owning an HP, an MBA icon,also sends a strong signal to others thatyou are serious about numbers.)Per the tables at Appendix A, theaccumulated value factors for varying ratesand investment periods at 10 percent are:
  • 413. Accumulation FactorsUsing our factors on Scenario B, on the$163,000 received at the end of Year 1 andinvested for two years till the end of Year 3,the accumulated value is:Year 1’s $163,000 × 1.2100 = 197,000 in 2years or $ 197,000$163,000 = $34,000 ofreinvestment incomeWhen evaluating projects or investmentsthat extend into the future, it is not only themagnitude of the cash flows that isimportant, but also the timing and thesubsequent use to which those flows canbe reinvested.
  • 414. Net Present Value (NPV)Accumulated value analysis is a good toolto determine how much a retiree needs toinvest today to have an adequate pensionin thirty years, but it doesn’t solve theproblem of evaluating investments andprojects today. Investments need to beevaluated in today’s dollars. How much isQuaker’s milling project worth today? Howdoes it compare to a similar piece ofequipment that costs $150,000 but lastsfour years?Cash flow analysis determines the flowsand the NPV technique values them intoday’s dollars. In that way differentprojects can be compared regardless oftiming.If Apple Computer, for example, knows thata new Tangerine computer will be a
  • 415. surefire $100 million hit, but that it will taketen years to develop, it may not makesense to invest in this project. Not only willthat $100 million be worth less due toinflation, but Apple could also use themoney to invest in robotics, which will saveApple production costs today. Even if anNPV analysis justifies the Tangerine, theremay be strategic reasons that overshadowit. That’s where the MBA must usemanagement judgment.Securities analysts see stocks and bondsas an equipment purchase. The stocksprovide dividend payments and bondsprovide interest payments in the future. Thesecurities’ values lie in the present value oftheir future cash flow. Just as Quaker Oatsuses NPV analysis to evaluate the merits ofbuying a new piece of production
  • 416. equipment, corporations evaluate newfactories, and the worth of increasedadvertising. Lawyers involved in wrongfuldeath suits can use net present valuetechniques to value the total of anindividual’s future earnings whenconsidering a settlement. The basic idea toremember is: A dollar today is worth morethan a dollar received in the future.The Quaker Oats project yielded $163,000over three years (51 + 51 + 61). Aspreviously calculated, the $163,000 in cashflows would yield an additional $34,000 ifthe cash produced was reinvested at a rateof 10 percent in other company projects oran interest-bearing investment. Would youpay $163,000 for $163,000 to be receivedover three years? Of course not! You wouldbe giving up the time value of money, or
  • 417. $34,000.Using this simple logic, NPV analysis takesfuture cash flows and discounts them totheir present-day value. This is the inverseof accumulated value. The formula is asfollows:NPV = ($ in Future) × (1 + Discount Rate)Number of periodsOne dollar received one year from now,with a discount rate of 10 percent, would beworth:$1 × (1 + .10) 1 = .90909Using this formula, tables of discountfactors tell the NPV of $1 at varying ratesand for varying periods. Considering the 10percent reinvestment opportunitiesavailable and the project’s riskiness, $1 inthe future is worth the following amounts
  • 418. today per the formula and tables:Discount FactorsThe cash flows of the Quaker project wouldbe valued in the following way:Future Cash × Discount Factor = NPVThe evaluation of any project depends onthe magnitude of the cash flows, the timing, and the discount rate, 10 percent in our
  • 419. case.The discount rate is highly subjective. Thehigher the rate or hurdle rate the less adollar in the future would be worth today(see the Appendix). It is called a hurdle ratebecause a project with a higher discountrate must generate more cash in the futureto be worth the same value of today. Theproject thus has a higher hurdle to jump tostay even. In cases where the futureoutcome of an investment is risky, as in ouroil well example, a higher discount rate isappropriate. If the outcome of aninvestment is certain, as in the investmentin a labor-saving device or in a UnitedStates Treasury Bond, a lower rate iswarranted. Companies not guided by anMBA’s expertise will use only one hurdlerate for all investment decisions and
  • 420. thereby ignore the relative riskiness ofprojects. They end up rejecting sure things,and chasing high-risk projects. Under nocircumstances should the interest rate of acompany’s bank debt be the rate that isused, unless it is just coincidence. The riskof the project should determine thediscount rate. Very stable companies canborrow at very low interest rates, but theycan invest in risky projects.Internal Rate of Return (IRR)IRR is a derivative of NPV. Simply stated:The internal rate of return of an investmentis the rate at which the discounted cashflows in the future equal the value of theinvestment today.To find the IRR one must try differentdiscount rates until the NPV equals zero.(Of course the HP calculator yields the IRR
  • 421. at a push of a button!) For the Quakerproject the IRR is 26.709 percent. Toconfirm that number we can calculate thefollowing:Using “26.709% Discount Factors”Using IRR to rank projects is useful, but itdoes not consider the magnitude of thevalues. A small investment withproportionately large returns would beranked higher than very large investmentswith adequate returns. If General Electrichas a billion dollars allocated to research, itneeds to deploy large sums of money tolarge projects that may have lower IRRs.
  • 422. Ranking by IRR also neglects the hurdlerates or discount factors used in NPVanalysis. Those hurdle rates, as I said,adjust for risk. All things being equal, theinvestment in equipment by Quaker mayhave a lower IRR than highly speculativeresearch into a Swedish cancer cure byMerck, but the Quaker project could have ahigher NPV. The equipment project’ssmaller cash flows would be discounted ata 10 percent rate because of the lower riskinvolved. This could result in higher NPV.The cancer research would be assessedusing a very high discount rate of 50percent. Remember, the higher thediscount rate, the less the cash is worthtoday and the more risk is implied. Probability Theory
  • 423. Probability theory is a nice word forstatistics, the subject that creates fear inthe hearts of even the brightest CPAs inbusiness schools. Actually, probabilitytheory is a more accurate term because itdescribes how statistics are used to solveproblems. Given the probabilities of strikingoil, what should Sam do? Out of eighthundred married MBA students in the TopTen programs, how many spouses arelikely to be ignored during the first year ofthe MBA program? It’s all probabilitytheory. Because most businesspeople shyaway from statistics, here is an opportunityfor MBAs to excel. I took a statistics courseas an undergraduate and learned virtuallynothing because I was taught theory, notproblem solving. MBA programsconcentrate on the practical aspects ofstatistics and tend to leave theory for
  • 424. mathematicians to sort out. If you are notfamiliar with statistics do not skip thissection. I cannot make you statisticallyproficient in a few pages, but if you give it achance with some patient reading, Ipromise you that you will have enoughworking knowledge of the discipline to askfor help whenever appropriate. Preparingstudents by giving them a workingknowledge of different subjects is the mainthrust of an MBA education. In only twoyears, professors do not expect theirstudents to become technical experts, butthey expect them to recognize where theyshould seek the help of an expert to solve aparticular problem.Probability DistributionsIn situations where multiple outcomes arepossible, the result is a distribution of
  • 425. outcomes. Each possibility is assigned aprobability. Through careful analysis,intuition, and judgment, all the possibleoutcomes of any event add up to 100percent, like the event fork of a decisiontree. The graph that shows a distribution ofoutcomes is called a probability mass ordensity function. If there are many possibleoutcomes, the curve is smooth and iscalled a probability density function. If thereare only a few, an uneven curve is drawn,called a probability mass function.A Rainfall Example. Rainfall in Seattle is anevent resulting in a probability distribution.Seattle’s rainfall, using hypothetical data,looked as follows in a table and inprobability distribution charts on the nextpage.
  • 426. Seattle Daily Rain MeasurementsApril 2000Probability Mass Function of RainMeasures
  • 427. Daily Rainfall in Seattle April 2000 (31stdays)The Binomial DistributionFlipping a coin results in two possibilities,heads or tails. Therefore the distribution ofoutcomes of two coin flippings could have
  • 428. several possible outcomes if you consider“heads” a success.2 successes, Heads/Heads1 success/1 failure, Heads/Tails,Tails/Heads2 failures, Tails/TailsCoin flipping gives rise to the most basic ofdistributions, called a binomial distribution.There are two outcomes in a binomialdistribution, success and failure, each withan equal likelihood of occurring.Seemingly arcane binomial distributiontheories can be applied to such practicalpursuits as stock market analysis. Successin a stock analysis would be a positivereturn on a stock in a month, and failurewould be a loss or break even. In a study ofAT&T share prices from 1957 to 1977,
  • 429. each month was examined to determinethe rate of positive returns. It was foundthat 56.7 percent of the time there was asuccess.The months studied were grouped intoperiods of three months each (quarters).Researchers noted that the frequency ofactual successes was as follows:A coin-flipping mathematician createdtables of numbers to solve all binomialdistribution problems. In the AT&T case,
  • 430. the information needed to use a binomialtable is:r = number of successes possible = 0 to 3n = number of trials = 3 (3 months in aquarter)p = probability of success = 56.7%Using this information, a binomial tablepredicts that the expected outcomes shouldbe:
  • 431. Surprisingly, the binomial distributionmatches rather well the actual results of theAT&T case. Given a guess of probability ofsuccess (p), the probability of positivemonthly returns in a given quarter could beread off the table. Binomial distributiontherefore has practical applications forassessing probabilities for portfoliomanagers, sales directors, and researchanalysts.The Normal Distribution: The Mystery of theBell CurveThe normal distribution is the most widelyused distribution and is most commonlyknown as the bell curve. At Harvard the bellcurve is used to determine grades. Thecurve dictates that 15 percent of the classreceive “Low Passes” (“loops”). At theDarden School, the professors use their
  • 432. judgment to dole out unsatisfactory marksof C or F. The result is two campuses withvastly different competitive environments.The Bell-Shaped Grading CurveWhen a probability mass function is basedon many trials, the curve tends to fill in andbecome bell shaped. We call this aprobability density function. Such was thecase with the two graphs describing rainfall
  • 433. in Seattle. The hump in the middle iscaused by the Central Limit Theorem. Itstates that “the distribution of averages ofrepeated independent samples will take theform of the bell-shaped normal distribution.”Why? Simply because a large number ofindependent samples tend to a centralaverage.Probability Density Function of RainMeasurementsDaily Rainfall in Seattle 1970–2000 (10,950days)
  • 434. Inches of RainThe concept of “averages of samples” is apretty vague one. In case applications thedefinition expands to include any largegroup of data. Why? Because the normaldistribution is so easy to use and closelyapproximates reality anyway. Stock pricesare the result of many market fluctuations
  • 435. that culminate in a return (profit or loss).The return can be considered an “average”of those market fluctuations. Just aboutanything can be rationalized as an average,hence the usefulness of normaldistributions.Probability Density Functions with Curvesof Different Standard Deviations
  • 436. Measures of the Normal Curve. The bell-shaped curve is described by two terms,the mean and its standard deviation (SD).The mean () is the center of the curve. Themean is commonly called the “average.” Itis the result of adding up the data anddividing by the number of data points. Thestandard deviation () is how wide the curveappears. The SD can also be described asa measure of the “variability from themean.” These two terms are central to mostprobability concepts.Other less-used measures of averages fora set of data are the median, the item in themiddle of the list if sorted by size, and themode, the item occurring most frequently ina data set.As with the binomial distribution, the sum ofall the outcomes as represented by the
  • 437. region under the curve equals 100 percent.What makes the normal distribution’s curvespecial is that for any given SD measureaway from the mean or the center, thesame probability exists for an event despitethe normal distribution’s shape.Normal Distribution of Shoe Sizes
  • 438. Normal Distribution Retailing Example. AlBundy, a shoe store owner, wants to makesure he has enough stock for all sizerequests. He purchased a study of ladies’shoe sizes from the Academy of Feet andreceived a stack of research data fromsurvey responses.He plotted the data on graph paper and itappeared as a normal distribution. He alsoentered the series of sizes in his calculatorand hit the “Standard Deviation” key. Theanswer was 2. Al also took the average ormean of all the surveys’ respondents’ sizesand found it to be 7. Looking at the graphhe created, he saw that it looked like ourtrusty normal distribution.Just by recognizing the shape, Al couldapply the laws of the normal distributioncurve. The laws governing the area under
  • 439. all normal curves are the following:1 SD = .34132 SD = .47723 SD = .498654 SD = .4999683Using these rules, if Mr. Bundy stocks sizes5 to 9 he has covered .6826 (2 × .3413) ofthe population. Increasing the sizes to 3 to11, he has covered .9544 of the feet outthere. If Al stocked sizes 1 to 13, .9973 ofcustomers at his store would be satisfiedwith his selection. He can always special-order for those feet beyond sizes 1 to 13.Of course normal distribution tables havebeen developed to determine theprobability for any specific point on the
  • 440. curve (non-integer SDs away from themean). To use the tables, a Z value mustbe calculated.The Probability Density FunctionMonthly Stock Returns of Pioneer Aviation
  • 441. A Normal Curve Finance ExampleLet’s apply these new pieces of probabilitytheory to finance. The monthly stockreturns of a volatile stock, Pioneer Aviation,are assumed normally distributed as shownby a plotted graph. A summary of historicalreturns shows a mean (center) of 1 percentand an SD (dispersion) of 11 percent.Gerald Rasmussen wanted to know whatwas the probability that next month’s returnwould be less than 13 percent.Using our new Z value tool we can figure itout:The normal distribution table I haveprovided in the Appendix tells us that 1.09SDs = .3621. The entire left side of the
  • 442. graph equals .5000, as any complete halfof the distribution would. This holds true inall situations. There is a 50 percent chanceof being above or below the center or meanin any normal distribution. Combining thosepieces of information, I calculate there is an.8621 (.3621 + .50) probability that therewill be a return of less than 13 percent andconversely a .1379 chance that it will begreater (1 .8621). This is a real-worldanswer to a real-world business problemusing statistics as our tools.The Probability Density FunctionMonthly Stock Returns of Pioneer Aviation
  • 443. Statistics is not difficult if you do not dwelltoo long on theory. Other distributions exist,but are rarely used in business. ThePoisson Distribution (pronounced“pwasaun”) is similar to the normaldistribution but has a flaring tail on the rightside of the graph. But most distributions areassumed to be normal to take advantage ofthe normal distribution’s laws of standarddeviations.
  • 444. Cumulative Distribution FunctionsA cumulative distribution function (CDF) isa cumulative view of a probabilitydistribution. It takes a probability massfunction, such as a bell curve, and asks,“What is the probability that the outcome isless than or equal to that value?” Thenormal curve tells you what the probabilityis for a given outcome, but the CDF tellsyou the probability for a given range ofvalues. The CDF can also be used to marryour knowledge of uncertainty (probabilitytheory) to our decision-making tool(decision trees). A CDF captures the rangeof possible outcomes of many-valueduncertain quantities.To continue our oil well example, let’s takethe distribution of the possible values of oilthat may be in the ground if oil is
  • 445. recovered:In the tree constructed before, we used$1,000,000 as our payoff. That amount wasthe expected value (EMV) of the oil,because I conveniently chose it for the
  • 446. example. The distribution was actually awide range of values. There was a .005chance of a $6,000,000 payday and .005chance of $50,000 as shown by the table ofvalues. If you multiply each of the dollarvalues by their individual probabilities in thesecond column, the EMV equals$1,000,000, the EMV we used before.Constructing a cumulative distributionfunction allows decision makers to arrive atthe mean or EMV when they are not certainwhat it is to begin with. Drawing a CDF is amethod of combining a series of yourjudgments about the probability of theupper, middle, and lower bounds of anunknown outcome to arrive at an EMV touse for decision making.The CDF graph of ranges of outcomesresembles a big S. In the CDF, you see at
  • 447. a glance all the possible outcomes, not juststatic individual points. As shown by thefollowing graph, Sam Houston believes thatall his possible outcomes fall in thecontinuous “range” of $0 to $6,000,000.The range of probabilities from 0 to 1.0 inthe CDF is divided into fractiles, or slices,using the bracket median technique. TheCDF above is divided in that way. To dividethe CDF probability ranges into fivefractiles, for example, one would take the.1, .3, .5, .7, and .9 fractiles. Each of thosefractiles would represent the average of the“ranges of values,” 0 to .2, .2 to .4, .4 to .6,.6 to .8, and .8 to 1.0, respectively.The .5 fractile is the same as the median,because half of the values are on eitherside of it. The median is not necessarily thesame as the mean we used as the center
  • 448. of the normal distribution. The median ismerely the center of the value range. Themean is the result of multiplying all theprobabilities by the values, as was done toarrive at the $1,000,000 EMV for an oildiscovery.To marry this CDF concept to the decisiontree to make important managementdecisions, imagine how you wouldrepresent all the values an oil well mayproduce. It would be a range of values thatwould be represented by a fan ofpossibilities. One could not possibly drawthe infinite possibilities of branches on thetree, so we use a CDF to help out.Cumulative Density FunctionValues of Possible Oil Drilling Outcomes(in thousands of $’s)
  • 449. Drawing a CDF. To draw a CDF as shownabove, you use your own judgment andyour research data. You need to askyourself a series of questions:What value would occur where results areeither higher or lower 50% of the time (themedian)?
  • 450. What value would be at the low end (.10fractile)?What value would be at the high end (.90fractile)?With the answers to these questions, youcan draw the CDF of what you believe therange of outcomes is. By picking fiveoutcomes using the five fractiles from theCDF, you can draw the event fan of fivepossibilities and probabilities on a decisiontree as five branches.The expected monetary value is the sameas in our first go-around, but that is onlybecause I conveniently used the correctEMV to begin with.A shortcut to using five fractiles is calledthe Pearson Tukey Method. Instead of five
  • 451. fractiles, the method uses only 3—the .05,.5, and .95 fractiles. Their respectiveprobabilities are .185, .63, .185.Decision Tree of Oil DrillingUsing the Cumulative Distribution FunctionFor large problems the decision tree hasbeen computerized by Monte Carlosimulation programs. The tree and the
  • 452. parameters of the “event fan” CDFs areincluded in the computer model. Theprogram runs many simulations to give youan idea of how things may really turn out.Some Fortune 500 companies use it.CDF and fractile analysis can be used forsituations where the EMV of a branch of adecision tree is uncertain. However, thejudgment of the analyst is most important.The tree is simply a tool that the MBA mustuse in tandem with his or her knowledgeand intuition. Regression Analysis and ForecastingLinear regression models are used in avariety of business situations to determinerelationships between variables thatanalysts believe intuitively to be related.
  • 453. Once a relationship is established, it can beused to forecast the future. Commonlyregression analysis is used to relate salesto price, promotions, and market factors;stock prices to earnings and interest rates;and production costs to productionvolumes. But of course one can use it aswell to find answers to questions such as,“What is the effect of temperature on thesales of ice cream cones?” Theindependent variable (X) in this scenario isthe temperature. It is the variable that isbelieved to cause other things to happen.The dependent variable (Y) is sales.Temperature affects sales, not vice versa.Regression analysis involves gatheringsufficient data to determine the relationshipbetween the variables. With many datapoints, such as a year’s worth of
  • 454. information on temperature and saleschanges, a graph can be drawn withtemperature along the X axis and salesalong the Y axis. The goal of regression isto produce an equation of a line that “best”depicts this relationship. Regression tries to“fit” a line between the plotted data pointsso that the “squared differences betweenthe points and the line are least.” The leastsquares method requires a great deal ofadding, subtracting, and multiplying. Abusiness calculator or computerspreadsheet program will be necessary.An Algebra Refresher CourseTo set the stage for a regression example,let’s review some basic algebra. You recallthat a line is described by this algebraicformula:
  • 455. Y = mX + bY = dependent variable (such as sales)m = the slope of the line (the relationshipbetween variables)X = the independent variable (such as rain)b = y axis intercept (where the line crossesthe vertical axis)The computer spreadsheet will calculatethe linear equation (Y = mX + b) thatdefines the relationship between theindependent and dependent variables. Theprogram will determine whether the linethat it has calculated as the best “fit” can beused as an accurate tool for forecasting.An Ice Cream Regression ExampleThe owner of a chain of twenty Ben &Jerry’s ice cream shops noticed that as thetemperature rose and fell, so did his sales.
  • 456. In an attempt to determine the precisemathematical relationship between salesand seasonal temperatures, he gatheredthe monthly sales data for the previous fiveyears and the average temperatures for themonths in question from the NationalWeather Service. His data looked asfollows:
  • 457. Using the “Regression” function of thespreadsheet, the owner generated thefollowing output:
  • 458. What Does This Mean?Wondrously enough, that block ofinformation contains the equation for theline that describes the relationship betweentemperature and sales at Ben & Jerry’s.First let’s interpret the data in the output toget the line equation.“Coefficient of the Y Intercept” = b =379,066“X Coefficient” = m = 16,431Placing that information into a standardlinear equation as described in the algebra
  • 459. refresher, Y = 16,431 X 379,066, plottingthe data points, and drawing the regressionline described by the equation, the graphlooks like this:Sales of Ben & Jerry’s Ice CreamRegression ExampleAs shown by the graph, the regression lineruns through the middle of the data points.By plugging temperature, X, into the
  • 460. equation, the predicted ice cream sales canbe calculated. In Ben & Jerry’s case, atemperature of 60 degrees would result inpredicted monthly sales of $606,794.Y = (16431 × 60 degrees) 379,066 =$606,794But just how accurate is this equation inpredicting the sales of ice cream? Theanswer to this question is given to us byanother number in the “Regression Output.”R Square ExplainedThe R Square value tells us “what percentof the variation in the data is explained bythe regression equation given.” In our case70.4 percent of the variation of sales isexplained by the regression equation. Thisis considered very high. In broader
  • 461. economic analyses, an R Square of 30percent would be considered very high,since there are thousands of variables thatcould affect economies. In the ice creambusiness, one could imagine that inaddition to temperature, store advertising,couponing, and store hours could alsoexplain sales fluctuations.But be careful! Do not read too much intothe regression data results! Regressiononly says that changes in sales occur withchanges in temperature in much the sameway as described. It does not say that“temperature actually caused sales tomove.” But if a selected independentvariable is reasonable and it is a goodpredictor of the desired dependent variableunder study, use it.
  • 462. Regression analysis points not only topositive correlations, such as ice creamsales and temperature, but also to negativecorrelations such as interest rates andhousing sales. If interest rates are high,housing sales are low. In this case the Xcoefficient is a negative number. Thesenegative relationships are just as usefulpredictors as positive/positive relationships.Standard Error ExplainedThe “Standard Error of the Y Estimate andthe X coefficients” shown in thespreadsheet output are synonyms for thestandard deviations of the Y and Xcoefficients of the regression line. In theBen & Jerry’s example, the standard errorof the Y estimate (sales) is plus or minus$243,334 68 percent of the time. In thesame way the output shows that the
  • 463. standard error of the X coefficient(temperature) is 3,367. A variety ofanalyses about the ranges of possible datavalues can be performed using standarddeviations to show the variability of thosenumbers and the reliability of the resultingregression equation.The T Statistic Measure of ReliabilityThe T statistic can help determine if theregression equation calculated by thespreadsheet is a good one to use forforecasting. The T statistic reveals if an Xvariable has a statistically significant effecton Y, such as temperature’s effect onsales. You calculate the measure bydividing the X coefficient by its “StandardError.” The rule of thumb says if a Tstatistic is above 2 or below /minus;2, the Xvariable has a statistically significant effect
  • 464. on Y. In our case 16,431/3,367 = 4.88, avery high T-stat. Therefore, an analystwould conclude that temperature is a verygood predictor of sales.When considering whether a model is agood forecaster, it is necessary to haveboth a high R Square and a high T statistic.It is possible to create a model with morethan one X variable. This is calledmultivariable regression. As the number ofvariables increases, so does the R Square.However, adding more X variables with lowT statistics creates an inaccurate model. Itis necessary to play with the model, addingand dropping independent variables toachieve high R Squares and high Tstatistics.Dummy Variable Regression Analysis
  • 465. A trick employed in regression analysis isthe use of dummy variables to representconditions that are not measured in anumerical series. Ones and zeroes areused to represent these conditions. Forexample, at Toys “R” Us, having the “hot”toy of the season in stock, a nonnumericalcondition, catapults sales. The in-stockcondition could be indicated in a data setby a “I” and out-of-stock condition could bedesignated by a “0,” using dummyvariables.Given a hypothetical set of data at a Toys“R” Us store, you can see how it works.
  • 466. The following regression output of therelationship between “hot” toys and sales isthe result.
  • 467. This is a perfect model because thevariation explained by the model’s RSquare is 100 percent and the T statistic isexcellent. The T statistic approaches infinity(100,000/.0009). The sales are $100,000without the desired toys, and an extra$100,000 when they’re in stock. Theregression equation, using the spreadsheetoutput, isSales = $100,000X + $100,000
  • 468. If the coveted toys are in stock, X = 1 andsales jump to $200,000. If not, X = 0, andsales total $100,000. Dummy variables arevery useful and can be used to matchnonscaled data, such as stock status or aholiday, with other regularly scaled data,such as temperature, interest rates, andproduct defects, to produce usefulregression models.Other Forecasting TechniquesTime series techniques forecast outcomesbased on changes in a relationship overtime. In our ice cream example, the datapoints of temperature and sales werecharted on the graph without regard towhen they occurred. The regressionrelationship did not consider time.Obviously seasons affect Ben & Jerry’ssales. Time series analysis considers time
  • 469. by plotting data as it occurs. The techniquethen attempts to “decompose” thefluctuations within the data into three parts:- The Underlying Trend—Up, down, flat (a long-term measure)- The Cycles—Hourly, daily, weekly, monthly (a short-term pattern)- Unexplained Movements—Unusual or irregular movements caused by unique events and quirks of natureRegression and moving averages are usedto determine the trend and cycles. As youcan imagine, time series forecasting is atedious process that does not lend itself toa short and simple example. However, it ishelpful at least to know that time seriestechniques exist.
  • 470. SummaryThis chapter has described the quantitativetools that perform the following functions:Sort out complex problems with decisiontreesDetermine the value of cash received in thefuture—cash flow analysis and net presentvalue analysisQuantify uncertainty with probability theoryDetermine relationships and forecast withregression analysis and other forecastingtechniquesThese are practical tools that MBAs use tomeet business challenges. They give MBAsthe power to make informed decisions and
  • 471. to distinguish themselves on the job. Key QA TakeawaysDecision Trees—A way to graphically showand quantify multiple outcomes of abusiness decisionSunk Cost—Investments made in the pastthat have no bearing on future investmentdecisionsExpected Monetary Value (EMV)—Theblended value of a decision based on theprobabilities and values of all possibleoutcomesAccumulated Value—The total future valueof cash flows with all earnings reinvestedNet Present Value (NPV)—The totalpresent value of all cash flows “discounted”to today’s dollars
  • 472. Internal Rate of Return (IRR)—Thediscount rate that makes the Net PresentValue of the cash flows equal $0 in today’sdollarsProbability Distributions—The graph of allpossible outcomes with their respectiveprobabilities of occurringBinomial Distributions—Probabilitydistribution with only two possibleoutcomesNormal Distributions—The bell-shapedprobability distribution of all possibleoutcomesStandard Deviation ()—The measure of thedispersion (width) of the normal distributionMean ()—The arithmetic average of alloutcomes
  • 473. Z Value—A tool to measure probabilities ofspecific situations on the normal distributioncurveCumulative Distribution Function (CDF)—Aform of the normal distribution that showsthe probability of being less than or equal toall possible outcomesRegression—A mathematical method offorecasting using line equations to explainthe relationships between multiple causesand effects Day 6 Finance Finance TopicsBusiness Structures
  • 474. Beta RiskThe Efficient FrontierCapital Asset Pricing ModelThe Efficient Market HypothesisInvestment ValuationsDiscounted Cash FlowsDividend Growth ModelCapital BudgetingCapital StructureDividend PolicyMergers and AcquisitionsI want to be an investment banker. If youhad 10,000 shares I sell them for you. Imake a lot of money. I will like my job very,very much. I will help people. I will be amillionaire. I will have a big house. It will befun for me.
  • 475. —Seven-year-old schoolboy, “What I Wantto Be When I Grow Up,” March 1985 (fromMichael Lewis’s Liar’s Poker, 1989)In the 1980s, finance was the place to be.Even kids dreamed of a life on Wall Street.Machiavellian young MBAs were besidethemselves with glee as a Wall Street hiredthem by the droves, offering them a shot atbig bucks trading and deal making asinvestment bankers. Unfortunately, thebubble burst in 1987 with the stock marketcrash and MBAs were forced to seek lessglamorous jobs by joining the financialstaffs at banks, corporations, and mutualfunds.Even though finance is no longer theglamour job it once was, MBAs are stilldoing quite well in finance. MBAs from thetop schools are put on the fast track and
  • 476. are paid significantly more than their non-MBA peers. On Wall Street MBAs maketwenty to thirty thousand dollars more peryear than non-MBAs in the same job.Moreover, job advancement is often limitedto the MBA elite.Do not read this chapter in isolation. Iffinance turns you on, a single-minded focuson this discipline could be hazardous toyour business health. Finance is veryquantitative, using numbers from theaccounting and QA chapters. Finance alsoplays as much of a role in marketing asmarketing does in finance. Marketers areresponsible for their financial results.Financiers work hard to market themselvesto new clients and to sell new stocks to oldones.
  • 477. The Nature of the FirmWhy do businesses exist? In a financier’seyes, the sole purpose of a firm is tomaximize the wealth of its owners. In theirpursuit of riches, there are several wayspeople can organize their businesses.There are three basic legal businessstructures that entities take on in the UnitedStates. Each is chosen depending on thecomplexity of the business, liabilitypreference, and tax considerations of theowners.ProprietorshipsA proprietorship, commonly called a soleproprietorship, is a business owned by anindividual or husband and wife. The ownerreaps all the profits and has unlimitedliability for all losses. If things go poorly, theowner’s personal assets can be seized. It’s
  • 478. a simple structure. As with a child’slemonade stand, no special governmentregistration is required. Earnings are addedto the individual’s other income and taxesare paid on the total income. Because it isnot a separate legal entity that can bedivided and sold in pieces, it is moredifficult for a proprietorship to raise moneyin the financial markets.PartnershipsWhen several individuals form a business,they often enter into a partnership. As in aproprietorship, each owner’s share of theearnings is included on his or her personaltax returns. Depending on the nature of thebusiness, there are two types ofpartnerships. In a general partnership,active owners, called general partners,have unlimited liability for all business
  • 479. debts. When the accounting firm ofLaventhol & Horwath went into bankruptcyin 1990 because of auditing malpractices,creditors went after the personal assets ofthe partners to pay off the partnership’sdebts.In a limited partnership structure, limitedpartners are shielded to the extent of theirinvestment. The “limited” form is often usedin real estate and oil explorations venturesto protect the investing partners that do notparticipate in management. In thecommercial real estate busts of the late1980s and early 1990s, the limited partnersin vacant office building projects were ableto walk away from their investments with nofurther liability. On the other hand, thegeneral partners of the same projects werepersonally on the hook. As in the
  • 480. proprietorship instance, the ability to raisemoney or to sell partial interests inpartnership structures is rather difficult.CorporationsCorporations, registered with a state, arelegal entities that are separate from theindividuals who own them. In the eyes ofthe law, a corporation is treated as anindividual who conducts his or her ownbusiness independently. The assets andliabilities of the entity are owned by thecorporation, not by the owners of thecorporation. As with limited partnerships,owners of corporations have limited liabilityfor the obligations of the business. In thecase of a bankruptcy, the owners’ personalassets are shielded from creditors.A corporation’s ownership is split intoshares of stock that investors can purchase
  • 481. and trade in the financial markets such asthe New York Stock Exchange. Shares canbe traded among investors withoutdisrupting the business. Whenmanagement and the board of directorswho represent the owners decide that moremoney is needed, additional shares can beissued. An investor, whether he takes anactive role or chooses to remain passive, ispersonally shielded from the liabilities of thecompany.
  • 482. A major drawback of ownership in acorporation is double taxation. Thecorporation, like an individual, must paytaxes. When the corporation pays itsowners a dividend, that dividend is taxableagain as income to the individual.
  • 483. There are variations to the corporate form.The C Corp., as it is called by accountantsand lawyers, works as described above,but there is also a Subchapter S Corp.These corporations have thirty-five or fewerowners. They agree to include thecorporation’s earnings in their personal taxreturns as in the case of a partnership. Inthat way, the double-taxation hammer doesnot fall on the owners, while at the sametime the corporation’s limited liabilityadvantage is maintained:* * *If you are interested in finance, you cantake two different yet interconnectedroutes. There is the investments area,which is more glamorous, the thing thatfortunes, headlines, and stock quotes aremade of; and there is financial
  • 484. management, which is the “in the trenches”work that helps companies finance theirgrowth, pay the bills, and makeacquisitions. The two areas areinterconnected because the performance ofa business, for which the financedepartment is to a large extent responsible,affects its investors’ share of the firm’sprofits. Let’s start with the glamour. InvestmentsRisk and ReturnHow can I profit by owning a large or smallshare of a corporation or other business?This investment decision is really a two-pronged question: What is the potentialincome, and how risky is the venture? Thebasic concepts of discounted cash flowsand probability explained earlier in the QAchapter can be used to answer these
  • 485. valuation questions. Refer to them as youwould look up old class notes.A basic tenet of finance dictates that thereturn should be commensurate with therisk. If you know that an investment is asure thing, then you should expect a lowerrate of return in compensation for the lowerrisk. Accordingly, certificates of depositinsured by the Federal Deposit InsuranceCorporation (FDIC) pay low rates of return.Wildcatting for oil involves a great deal ofrisk, but it also promises a huge jackpot if awell turns out to be a gusher.Types of Risk. If risk applies to a wholeclass of assets, such as the markets forstocks, bonds, and real estate, it is calledsystematic risk. For instance, when thepublic believes that the stock market is agood bet (a so-called bull market), the
  • 486. market as a whole will climb. When thepublic leaves, the market “lays an egg” or“melts down,” as the headlines read in thecrashes of 1929 and 1987. Movements inthe economy, interest rates, and inflationare systematic factors that affect the entiremarket. In making any investment, you areexposed to the systematic risk of themarket.If the risk applies to a particular asset or toa small group of assets, it is called uniqueor unsystematic. An individual investmentperformance may be volatile because ofspecific risks inherent to the investment. Ifyou own shares in Disney, for instance, andMickey catches a cold, the stock couldtumble. That type of risk can be largelycompensated for by owning a number ofinvestments. This is called diversification.
  • 487. By holding a broad portfolio of investments,investors can offset losses on someinvestments with gains on others.Diversification moderates the overallfluctuations of a portfolio.Beta: Risk Within a Portfolio of InvestmentsThe market prices of stocks, IBM forexample, fluctuate daily on the stockexchanges of the world. That volatility isequated with risk. A distribution of historicaloutcomes would show the risk graphically,as was shown for Seattle’s rainfall and forshoe sizes in the QA chapter. To refreshyour memory of probability distributions, themean long-term historic return on commonstocks was 12.1 percent with a standarddeviation of 21.2 percent. Within onestandard deviation, 68 percent of the time,the stock market will return between +33
  • 488. percent and 9.1 percent per year.In addition to showing on a graph anindividual investment’s absolute volatility,financial analysts measure the risk ofindividual stocks or small groups of stocksby comparing their price movements withthe entire market’s movement. Thatmeasurement, beta, quantifies the risk ofholding that particular investment versusowning a very large portfolio thatrepresents “the market.” An example ofsuch “market” portfolios are the collectionof 500 stocks called the Standard & Poor’s500 (S & P 500) or the 5,000 stocks thatare included in the Wilshire 5000. TheNikkei index of 225 stocks represents theJapanese market.The famous Dow Jones Industrial Averageis a diverse collection of 30 of the most
  • 489. stable industrial companies in America(e.g., AT&T, IBM, 3M, GM, P&G, Coca-Cola, Boeing, and Exxon). The Dow’s thirty“blue chip” stocks are traded on the NYSEand are not representative of the broadermarket, even though the press might haveyou believe that they are.A Probability Distribution of Historic StockReturns
  • 490. If a stock or portfolio moves in tandem withthe market, it is said to be perfectlycorrelated with a beta of 1. Coca-Cola issuch a stable company that it moves withthe market with a beta of 1. If a stockmoves in perfect opposition to the market, itis said to be negatively correlated, or tohave a beta of 1.There are no such perfectly negativelycorrelated stocks, but there are somestocks with very low betas. Luby’sCafeterias has a .45 beta. When the marketfluctuates down wildly, older people still goto the cafeteria. However, in a big marketrally Luby’s is less likely to risedramatically. Electric utilities also have lowbetas. Theoretically, a beta of 0 wouldmean an absence of risk. In that case theinvestments’ betas would perfectly cancel
  • 491. each other so that there would be no riskregardless of the movement of the market.A risky stock, like America Online, anInternet company, has a beta of 1.75. A 1percent fluctuation in the market would bemagnified in a 1.75 percent movement inAOL’s price. Moderately risky stocks suchas IBM and Microsoft have 1.2 betas.How Investments with Different Betas ActThe behavior of the market is so importantbecause most large investment decisionsare made in the context of a large portfolio,
  • 492. or collection of investments. Although therisks of individual investments may be high,the overall risk will be lowered by investingin the right mix of investments in order tolower the portfolio’s beta. Large mutualfunds that own hundreds of investments,such as Fidelity’s Magellan Fund’s $50billion portfolio, provide this kind ofdiversification.Of course the beta number does notappear from nowhere. Beta is a statisticalcalculation of a correlation coefficient, thecovariance of a stock with the marketdivided by the variance of the market.Betas can be calculated, but financialanalysts will admit that investmentinformation services, such as the ValueLine Survey, provide the beta coefficients.Calculating beta is tedious, and in true
  • 493. MBA fashion, this book will skip it.The Efficient FrontierGiven all the possible portfolios of assets,theoretically there is a perfect mix ofinvestments at each level of beta risk. Thegraphical representation of thesetheoretical “best” portfolios lies on a linecalled the efficient frontier. The area belowthe efficient frontier line encompasses theattainable or feasible portfoliocombinations. Theoretically above thefrontier are the unattainable returns.The Efficient Frontier
  • 494. The Capital Asset Pricing Model for StocksThe capital asset pricing model (CAPM)determines the required rate of return of aninvestment by adding the unsystematic riskand the systematic risk of owning thisasset. A simple formula, the CAPM saysthat the required rate of return is the risk-
  • 495. free rate plus a premium for unsystematicrisk. That risk is the beta that you arealready familiar with.Ke = R f + (K m R f ) BetaRequired Return on an Equity Investment =Risk-Free Rate + (Avg. Market Return RateRisk-Free Rate) × BetaSuppose you wanted to know in 1992 whatIBM should yield to be a worthwhileinvestment. The Value Line Survey told youthat IBM had a conservative beta of 1.2.The Wall Street Journal told you that thelong-term risk-free United States TreasuryBond pays a return of 8 percent. The finalCAPM input requires some morehomework. A study conducted since 1926shows that the average return on the
  • 496. Standard & Poor’s 500 has exceeded therisk-free rate of investing in risk-free U.S.Treasury Bonds by 7.4 percent. With thosethree CAPM inputs, an investment in IBMshould return on average 16.8 percent.The Security Market Line
  • 497. 8% + (7.4%) 1.2 = 16.8%Plugging in many, many betas into thelinear algebraic equation of the CAPM, youcan generate a graph. That line is calledthe security market line (SML). In the IBM
  • 498. example, suppose that the return on IBM isactually 12 percent. That is less than therequired rate of return determined by theCAPM. The theory suggests that a rationalinvestor would sell IBM. If the return rateexceeded the required rate as determinedby the CAPM, then the market is offering abargain, and investors should buy thestock. It sounds great, but the CAPM tellsthe required rate of return, not what aninvestment will actually return. For that youneed tea leaves and a crystal ball. Forthose who invested in IBM in 1992, it was abargain. It climbed from $30 to over $200 in1999.Moreover, the whole CAPM is theoreticallyunder attack. In an article entitled “Bye-byeBeta” in Forbes, March 1992, DavidDreman, a noted investment advisor,
  • 499. reported on new and startling research, andpronounced CAPM and beta dead. A studyby University of Chicago professors Famaand French saw no link between risk, asdefined by the CAPM, and long-termperformance. Because betas are based onhistorical volatility, betas may have norelevance for future predictions. Betas mayhave fallen into disrepute, but since there isnothing better, business schools still teachthis theory.The Efficient Market HypothesisThe SML graph suggests that there arebargains in the market. But that begs thequestion, “If the market is efficient, thenhow can there be bargains?” The efficientmarket hypothesis (EMH) alleges that tovarying degrees the market reflects allcurrent information. Therefore, no one can
  • 500. take advantage of market aberrations to“beat the market.” Investors competing forprofits are so numerous that quoted stockprices are exact indicators of value.There are three degrees of belief in theefficiency of the market: weak, semistrong,and strong.Weak Form of Efficiency. All informationthat caused past price movements isreflected in the current market price.Believing in the weak form means that nobenefit is gained by charting stock pricemovements using technical analysis as apredictor of the future. However, by doingin-depth fundamental analysis aboutcompanies’ operations and profitability,analysts can gain insights that will provideopportunities for big profits.
  • 501. Semistrong Form of Efficiency. This campbelieves that market prices reflect allpublicly known information. Therefore,without insider information, no “abnormal”returns can be gained by poring overfinancial statements. The Securities andExchange Commission (SEC) acts as apoliceman to try to ensure that investors donot trade based on insider information.Believing in the semistrong form ofefficiency means that fundamental analysis,conducted by reading financial statementsand all public information, will not result inbig gains.Strong Form of Efficiency. The truebelievers in market efficiency have faiththat stock prices reflect all public and
  • 502. private information. That intense faith hasbeen proven unfounded in many instances.The criminal convictions of Ivan Boesky,Dennis Levine, and Michael Milken werewell-publicized cases in which insiderinformation was used to reap hundreds ofmillions in profits that the public had nochance of making.Research indicates that the weak form ofmarket efficiency has held true over time.Naïve beliefs in complete efficiency are notwarranted. Stocks are generally fairlyvalued, yet some people deny even theweak form of the efficient markethypothesis. As mentioned, chartists ortechnical analysts graph price movementsseeking patterns that will indicate pricemovement in the future.
  • 503. Investment Types and Valuation MethodsIn the QA chapter the concepts ofdiscounted cash flows and net presentvalue were covered in detail. A dollar heldtoday is worth more than a dollar receivedin the future. That simple concept, appliedto the cash thrown off by an investment, isin most cases the method used to valueinvestment.The Bond MarketA bond’s value comes from the presentvalue of its future cash flows. Bonds areissued by companies or governmentalagencies to raise money at fixed rates ofinterest. Most pay interest, a coupon,semiannually on the principal amount,called the face or par value. At the statedmaturity date, the principal is repaid.
  • 504. In most cases the longer the maturity, thehigher the interest rate that a company hasto pay investors. Higher rates compensateinvestors for tying their money up forlengthy periods. Investors could miss outon higher returns if the market rates gohigher; therefore, they must becompensated for that risk. The basicconcept that higher rates accompanylonger maturities is graphically depicted inwhat the investment world calls the yieldcurve. In 1992, it was upward sloping with a5 percent difference between short-andlong-term interest rates. In January 1999,the curve was flat with only ¾ of 1 percentdifference in rates.The Yield Curve for U.S. TreasurySecurites
  • 505. A Bond Valuation Example. In 1976Caterpillar Inc., the maker of heavyconstruction equipment, issued $200million worth of 8 percent coupon bondsmaturing in 2001. In June 1992, the pricefor the bond was quoted in The Wall StreetJournal as $100 for every $100 of facevalue. The value was determined not onlyby the rate of interest paid, but by threeother factors:
  • 506. The Stated Interest Rate (the coupon rate)The Length of Time Until MaturityThe Risk of Default of the Issuer(investment researchers publish ratings)The fact is that the market quote was $100.That indicated that the market valued the$100 payable in 2001, paying an 8 percentsemiannual coupon, from a stable companyat $100. The Moody’s bond rating serviceconfirmed a low default risk assessment bytheir “A” rating. Using the net present valueconcept, the cash thrown off by the bond,discounted at an 8 percent market discountrate in 1992, equaled the bond’s marketvalue. Because the market rate equaled thecoupon rate, investors paid neither apremium nor a discount on the face valueof the Caterpillar bonds. The bonds had an
  • 507. 8 percent yield to maturity (YTM) on the$100 market value of the bonds.Caterpillar Bond Valuation of DiscountedCash FlowsHere is the calculation in detail; normally,however, you should use a calculator to dothe math. Seeing it in this form helps you
  • 508. visualize the time value of money. If themarket thought Caterpillar was on theverge of bankruptcy, or if the marketinterest rates on all investmentsskyrocketed in a period of high inflation,then investors might have required a 20percent rate of return on their money. If thatwere the case, the $100 bond would havebeen worth only $49.69 and quoted at “4911/16” in the paper. The increasedriskiness of the cash flows would reducethe bond’s value. Conversely, a discountrate of 5 percent would have yielded amarket price of $123.16. In that case an 8percent coupon would be higher than themarket rate and investors would pay apremium for the higher cash flows.Time and Discount Rate Effects on PresentValue
  • 509. Graphically, cash discounted at higherrates is worth less. The further out the cashis received the less it is worth to an investortoday.Duration. Another way of evaluating a bondis by calculating a bond’s “averageweighted maturity,” called its duration.Duration is the time a bond takes to returnhalf of its market price to the investor. It
  • 510. also measures the sensitivity of a bond tochanges in market interest rates. Thefurther in the future a bond is paid out themore volatile its value. If a bond matures inone year, it would be considered a short-term bond; all the proceeds would be paidquickly and the bond’s volatility would below. Long-term bonds offer a fixed interestpayout over many years. If market ratesclimb, an investor is locked into lower ratesfor a long time. As a consequence, thebond will be devalued dramatically.In the case of the Caterpillar bond, it paidback $50 of the investors’ $100 investmentin nine years. That’s the bond’s duration.This is a long time for a bond; as aconsequence, its value respondeddramatically to swings in interest rates,from $49.65 with a 20 percent rate to
  • 511. $123.16 with a 5 percent rate.Don’t worry about the math—computers willdo the calculations for you. As a Ten-DayMBA, you can now ask your broker not onlyfor the bond’s yield, but also for its duration,and he or she will know that you are morethan a retiree looking for a safe investment.Other Types of Bonds. There are five moretypes of bonds of note: zero coupon bonds,consuls, convertible bonds, callable bonds,and junk bonds.A zero coupon bond bears no interest, butpays a lump sum at maturity. Investorsvalue the bond the same way as one thatpays interest, but there are no interestpayments to discount. For example, aDisney zero coupon bond maturing in 2005at $100 was valued at $46.875 in 1992.
  • 512. Using a calculator to do the math, a 6percent rate discounts $100 to be paid in2005 to a value of $46.875 in 1992. Thelow rate denoted that Disney was a strongcompany.A consul or perpetuity is a bond that neverpays back the principal, but continues topay interest forever. These bonds areunusual but they still are issued in theUnited Kingdom. The valuation technique isvery simple. The cash flow or interestpayment is divided by the discount rate. Ahypothetical example: London Telephoneagreed to issue a $100 consul that pays $8each year forever. If investors require a 10percent rate of return, the value would be$80 ($8/.10)
  • 513. Sometimes a company adds an even moreexciting provision called a conversionfeature to bonds. Convertible bonds areconvertible to common stock at apredetermined conversion ratio. Forexample, let’s assume that Caterpillar’s$1,000 face value of bonds was convertibleinto 10 shares of stock or $100 per share. IfCaterpillar’s stock price rose above $100per share, bondholders might considerconverting their bonds into common sharesof stock. Convertible bonds usually pay alower interest rate than nonconvertiblebonds, because they provide investors withan additional option.The fourth type of bond is a callable bond.In some instances issuers want the optionto buy back their bonds from the public ifinterest rates fall significantly after the issue
  • 514. date. In 1981, large corporations soldbonds paying 15 to 20 percent interest peryear, the prevailing market rates. Asinterest rates fell later, in the 1980s and1990s, the corporations that had included acall provision bought back their bonds atpredetermined prices and issued new onesin the early 1990s paying 7 to 8 percent tosave on interest expense. Because callprovisions limit unusually high rates ofreturn, corporations have to pay a higherinterest rate for the privilege of calling backthe bonds.The last classification, a junk bond, is abond that has a high risk of default. Oftentheir risk lies in the fact that they may besubordinated to the claims of other bondsissued by a company. These bonds payhigher rates to investors and most still pay
  • 515. their interest and principal on time. If thecompany does not have enough money tomake payments on its borrowing, thesubordinated debt holders get paid last.Junk bonds have been around as long asthere have been bonds. During the CivilWar the Confederacy issued risky bondsthat could be termed “junk” bonds. Billionsof junk bonds were issued for takeovers inthe late 1960s and during the leveragedbuyout binge in the 1980s, by such well-known firms such as RJR Nabisco, MCI,Macy’s, Metromedia, and Chrysler. Junkbonds are not “junk”; they simply have ahigher risk of default.Bond Valuation SummaryHigher Risk of Default Higher Market RatesHigher Disc. Rate Lower Bond Value
  • 516. Lower Risk of Default Lower Market RatesLower Disc. Rate Higher Bond ValueHigher Coupon Rate Shorter MaturityShorter Duration Value Less Volatile toMkt. Rate Chgs.Lower Coupon Rate Longer MaturityLonger Duration Value More Volatile toMkt. Rate Chgs.The Stock MarketStocks have no contractual terms ofpayment and no maturity. If earnings areadequate, most companies regularly paydividends to stockholders. But there are noguarantees. Building on the teachings ofaccounting, equity ownership of a company
  • 517. entitles the owner to the residual claim onearnings and assets after all the otherobligations, such as bonds, have been met.If there are no earnings, there’s little valueto the stock. With adequate profits, bondsare paid on time and hopefully there is aportion left for stockholders.Stocks are called by many names,depending on the company’scharacteristics.Classes of StocksClassDescriptionExamples Growth StocksRapidly Growing Companies CiscoSystems Blue Chip Stocks Very LargeCompanies Kodak, Coca-Cola CyclicalStocks Fluctuate Greatly with EconomyFord, GM Penny Stocks Risky, SmallCompanies with Low Share Prices JetElectro
  • 518. The Dividend Growth Model. One way thatinvestment analysts try to value stocks isby valuing the dividend cash flow. Thisvalue model heavily weights dividendgrowth in its formula. However, it does notalways yield a reasonable answer.D = Annual Dividends per ShareK = Discount Rate or Required Rate ofReturng = Annual Dividend Growth RateThe stock of Caterpillar Inc. is a goodexample. In 1992 the company paid a$1.20 yearly dividend per share. Using the
  • 519. CAPM equation, the required rate forCaterpillar’s beta of 1.2 was 16.8 percent,the same as IBM’s at the time. Caterpillar’sboard of directors had raised their dividendan average 12 percent for the last fewyears. With those inputs in the dividendgrowth model, the stock should have beenworth $25.But Caterpillar actually traded at $56 pershare in May 1992. Either there must havebeen more than just dividends to thecompany, or the market had gone nuts. Butprobably not. Investors must have alsovalued the company’s assets and futureearnings as well. Unlike IBM, Caterpillar didnot take off and traded at $60 in 1999.
  • 520. What is an analyst to do with Wal-Martstores, the discounter that pays very smalldividends? How do analysts value Internetfirms that have no earnings and nodividends? There are no easy formulas, butthe following are a few additional methodsused by securities analysts to calculatevalue.Price Earnings Ratio. Analysts compare theratio of the current stock price to the currentor projected earnings per share (EPS). Thisprice earnings ratio (PE ratio) is probablythe most widely used valuation method. It issimple. Everyone can divide price byearnings per share. Best yet, the EPS ofmost companies are widely published. Ifthat ratio is in line with the industry of thebusiness and with the market, then it may
  • 521. indicate the propriety of its current stockprice. To illustrate the wide use of the PEratio, the following was a stock picker’srecommendation:Corestates Financial at $44, the oldPhiladelphia National Bank, has a low priceearnings multiple relative to other banks,and its dividend yield is higher than otherbanks mentioned. Strong buying interestexists.Multiple of Book Value per Share. Thiscalculation using balance sheet informationdivides the share price by the book value ofassets per share. In 1992 ImCloneSystems, a biopharmaceuticals company,sold at 331 times its book value. Forbeshighlighted it as possibly overvalued, butthe ratios of small, new companies areoften unusual. Investors often value the
  • 522. potential success of start-up companies,not their current size. In this case,ImClone’s stock plummeted from a high of$26 in 1992 to $.31 in 1995 whenbiotechnology fell out of favor withinvestors. When sales materialized in 1998,it traded at $10 a share, 5 times its bookvalue.Multiple of Sales per Share. Sales dividedby stock price is the formula. In 1999 Ebay,Inc., an Internet auction site, had a sales-to-price ratio of 1,681. With very few sales,the multiple was very large. Investors werebuying the future of the Internet.Asset Value per Share. When a company’sassets value divided by the outstandingshares is more valuable than the price of
  • 523. the stock indicates, then analysts mightoverlook other ratios. The buyout binge inoil stocks was due to the fact that the shareprices were below the value of their oil andgas reserves. As a result, Getty, Gulf,Mesa, and Phillips engaged in a biddingwar that made their shares soar in the1980s.Multiple of Cash Flow per Share. Someanalysts value companies because of theirability to generate cash as measured by thecompany’s cash flow statement. InCaterpillar’s case, it produced $5.90 foreach share outstanding in 1992. At $56 pershare, the stock was priced at 9.5 timescash flow. Looking forward, analystsprojected $11.10 in 1993 and $17.80 inlater years, or three times the projected
  • 524. cash flow. That is where some bullishinvestors saw the value of Caterpillar. If agroup of analysts valued the $17.80 cashflow per year in perpetuity at a 16.8 percentdiscount rate, the stock would have a netpresent value of $100 (17.80/.168). Tothem, at $56 Caterpillar was still cheap. Asmentioned, it traded at $60 in 1999; theywere all wrong.In a stock market there are always buyersand sellers. Imbalances cause pricemovements. Many yardsticks of value exist,but the only one that truly matters is thecurrent quote, no matter how crazy it mayappear. If the market is willing to buyCaterpillar at $200, then that is its value. Ofcourse, if there is more supply thandemand, prices fall. But that’s for oureconomics chapter.
  • 525. Preferred Stock. This is the privilegedcousin of common stock. Preferred shares,a hybrid of a bond and a common stock,are issued by many utilities, banks, andsteel companies. Preferreds have thecharacteristics of a bond inasmuch as theypay a fixed dividend rate and have novoting rights. As in the case of commonstocks, their dividends can only be paid ifdebt payments are made first, and there isno maturity. However, most issuers makeprovisions to purchase and retire theirpreferred stock over time. A preferredstock’s claims on the assets of the firm aresuperior to common stock but aresubordinated to debt.Companies issue preferred stock whenthey want to borrow money but don’t want
  • 526. to be contractually obligated to pay intereston time. Most preferred issues arecumulative, meaning that the total of allunpaid dividends must be paid beforedividends on common stocks can be paid.Investors who like a more secure dividend,but like to have the benefits of partial equityownership, choose preferred stocks.The Options MarketOptions are contractual rights to buy or sellany asset at a fixed price on or before astated date. Options can be traded on realestate, bonds, gold, oil, and currencies. Anoption is a way to gain control of a greatdeal of assets with very little money. Theopportunity for profits is high, and,accordingly, so are the risks.Because these option rights are not theasset itself, they are called derivatives. Any
  • 527. security that is created that is valued basedon the value of another is a derivative.Stock options, stock warrants, indexoptions, commodity options, andcommodity futures are examples.Imagine G. R. Quick, a house buyer, whobelieves that prices are about to skyrocketin Beverly Hills. However, he needs sixmonths to raise the down payment and getfinancing. A willing owner agrees to sell himhis bungalow at $500,000, but wants$5,000 for the option to hold it off themarket for six months. For six months Mr.Quick, the option holder, has the right, butnot the obligation, to purchase the housefor $500,000. If the real estate market falls,Mr. Quick can let his $5,000 option expireat a 100 percent loss.
  • 528. But options can also be very profitable. Ifthe bungalow increases in value to say$550,000, the return on the $5,000 optionwould be 1,000 percent. If he buys thehouse outright for $500,000, his returnwould be only 10 percent. The essence ofoptions is to control the destiny of an assetwith an investment of a fraction of thatasset’s value. The payoff is a leveragedpayoff or a possible total loss if theunderlying asset’s value fluctuates.Stock options work in the same way as inthe real estate deal discussed. An option is“the right” to buy or sell a stock:at a stated price—the strike priceby a certain date—the expiration date
  • 529. at a cost for the privilege—the optionpremiumOptions to purchase stocks are called calls. (“Call” in the stock to buy.) Rights to sell astock to somebody else are called puts.(“Put” it to somebody else for sale.) Thevalues of call and put options move inopposite directions. If a stock price rises,then the value of a call option to buy it, at afixed price, increases. If a stock’s pricefalls, its call value decreases. Conversely,the value of a put option increases whenthe underlying stock price falls anddecreases when the stock price increases.On the Chicago Board Options Exchange(CBOE), the oldest and largest exchange,traders buy and sell options on blocks ofone hundred shares of stocks in the sameway as Mr. Quick bought an option on real
  • 530. estate. Buyers of stock options buy theright to the appreciation (calls) ordepreciation (puts) of a stock for a period oftime. Sellers, called option writers, ofcovered options sell to buyers the rights onthe stocks that they own. If an option writersells an option on a stock not owned, theoptions are called naked options. They arenot covered.The Way Option Values FluctuateUnderlying Stock Price Movement
  • 531. There are two types of option valuations,theoretical and market value. Thetheoretical value is the difference betweenthe underlying stock’s market price and theoption’s strike price. For example, a calloption to buy Coca-Cola at $40 when themarket price of the stock trades at $45would have a theoretical price of $5.However, options are written for extendedperiods of time. Therefore, the marketvalue is the sum of the theoretical valueplus a premium for the chance of profitableprice movements until the expiration date.As the date of expiration approaches, thereis less time for profits, so the premiumerodes. On the expiration date, the optionis settled for cash based on the optionedsecurity’s market value. The market valueequals the theoretical value because thereis no longer a premium for future gains.
  • 532. Option Valuations. In 1973 Fisher Blackand Myron Scholes published a model thatbecame the industry standard for optionvaluations throughout the world. In theBlack-Scholes Option Pricing Model, anoption’s calculated value is determined byfive factors:Time until expiration—The longer theoptioned time, the more chance of adesired price movement. That’s the timepremium.The difference between the current stockprice and the strike price—The closer thestrike price is to the current price the moreprobable it is that current price movementscan meet or exceed it by the expirationdate.
  • 533. The price volatility of the stock—The morevolatile the price movement of a stock, themore likely that a price movement couldjump near the strike price.The market rate of interest on short-termgovernment securities—If the cost offinancing the transaction is high, then theoption price has to be higher to cover thehandling costs of the transaction.Dividend payments on the stock—Optionowners do not collect the dividends on theunderlying stock, but the stock price thatinfluences the option price is affected.One can calculate the approximate pricesof calls and puts by placing these fiveinputs into a simple computer spreadsheet.Because everybody uses some form of theBlack-Scholes model, the prices produced
  • 534. by these models are very close to themarket price. That is in sharp contrast tocommon stock valuations, in whichinvestment analysts use thousands ofmethods to determine their own “correct”value.A Call Option Example. Optimistic stockoptions traders buy calls to purchase stockif they believe the underlying stock willincrease in the near term. For example,let’s call our options trader Billy Peligro. OnJune 15, 1992, Billy saw Wal-Mart storescommon stock quoted at $54 per share inThe Wall Street Journal. The call right topurchase one share of Wal-Mart bySeptember at $55 traded at $2.69. Billy betthat Wal-Mart would trade significantlyabove $55 by September (SEP), and he
  • 535. paid $2.69 for the chance. If the optionexpired on the day of purchase in June, theoption purchase price of $55 would havebeen “out of the money,” by one dollar, andthe option would be worthless. The value ofa $55 call option of Wal-Mart graphicallylooks like a hockey stick. It varies with thestock price.But is $2.69 the correct price? Plugging thefive factors of Wal-Mart’s common stockand the particulars about the option into theBlack-Scholes black-box spreadsheet, theoutcome for your author was a $2.66 price.Pretty close!The Value of a Wal-Mart SEP $55 CallOption
  • 536. Put Option Example. Let’s look at theopposite situation, a pessimistic BillyPeligro. He bought a put option to sell Wal-Mart at $55 for settlement in Septemberwhen the market price was $54 in June.That was one dollar “in the money”because he had the right to sell at $55when the market was at $54. The market
  • 537. price for the option was $2.75 on June 15,1992. One dollar of the value was “in themoney” and the other $1.75 was thepremium for three months to make moremoney. If the stock fell further, Mr. Peligrohad the right to sell a share of Wal-Martstock at $55, no matter how low it mighthave gone. Checking Black-Scholes forreasonableness, the $2.75 market valuewas close to the modeled value of the put.The put’s graph of possible values is thecall’s hockey stick in reverse.Options Strategies and Hedging. Optionsare highly risky investments, but their riskcan be reduced by hedging. Hedging isbuying an option to offset a possibledecline in value in an owned investment.Like other options, it can be taken on many
  • 538. types of assets. Suppose that a risk-adverse investor, Mr. Scared E. Cat, ownedthe same share of Wal-Mart stock tradingat $54, but because of the downside risk,he wanted to protect himself from a steepdecline. The investor could have bought athree-month put option at a $50 strike pricefor $1 in June 1992. The put would haveensured that he could have sold his Wal-Mart share for at least $50 in the next threemonths. The person who wrote the optionbelieved that there was little risk of thathappening and was happy to take the $1premium, hoping it would have no value toMr. Cat.The Value of a Wal-Mart SEP $55 PutOption
  • 539. If Wal-Mart fell to $40, the put option thatcost only one dollar would be worth $10 atexpiration. The put writer would beobligated to pay up. For Mr. Cat, theoption’s $10 gain would partially offset the$14 loss in the value of the stock from $54to $40. That is why many people view theoptions market as a way to shift risk fromone investor to another. In the case of Wal-
  • 540. Mart, the stock fell as low as $21.50 in1996 and a long-term hedged positionwould have been good. However, by 1999,it recovered and soared to over $100 pershare.There are many options strategies thatoption traders and portfolio managers usein addition to simple hedges. Sophisticatedinvestors combine options and stocks inmany ways. There are many optionstrategies that traders use, includingspreads, butterflies, condors, straddles,and boxes.In addition to put options, an investor canshort a stock if he or she would like to betthat a stock’s value will decline. In thistransaction you borrow the stock to sell it,with the hope of repurchasing it later at alower price. And just as with options, short
  • 541. selling can be part of a hedging strategy. Financial ManagementHow a company funds itself and maximizesthe return on money raised from itsshareholders or debt holders is theessence of financial management. MBAswho choose to go into financialmanagement perform two major functions:Business Investment Decisions—Whatassets should the firm own? In whatprojects should the business invest?Financing Decisions—How should thoseinvestments be paid for?Business Investment DecisionsThere are many investments that acompany can make. It is a financialmanager’s job to help the management
  • 542. team to evaluate investments, rank them,and suggest choices. The MBA term forsuch activity is capital budgeting.In the Quantitative Analysis chapter, theQuaker Oats example described thetechniques used to decide whether or notto invest in new cereal filling equipment.Quaker managers used discounted cashflows to calculate the net present value(NPV) of the project. In the marketingchapter, the decision to launch a newcoffee brand was evaluated by a simplermeasure, the payback period. Someinvestments, however, defy financialanalysis. Charitable donations, forexample, provide intangible benefits thatfinancial managers alone cannot evaluate.Investment decisions fall into one of threebasic decision categories:
  • 543. Accept or Reject a Single InvestmentProposalChoose One Competing Investment overAnotherCapital Rationing—With a limitedinvestment pool, capital rationing tellswhich projects among many should bechosen.Each corporation uses its own criteria toration its limited resources. The major toolsthat MBAs use are:Payback PeriodNet Present Value
  • 544. Payback Period Method. Many companiesbelieve that the best way to judgeinvestments is to calculate the amount oftime it takes to recover their investments:Payback = Number of Years to RecoverInitial InvestmentAnalysts can easily calculate paybacks andmake simple accept or reject decisionsbased on a required payback period. Thoseprojects that come close to the mark areaccepted, and those falling short arerejected. For example, the managers of asmall company may believe that all energy-and labor-saving devices should have amaximum three-year payback, and that allnew equipment should “pay back” in eightyears, whereas research projects shouldpay back in ten years. Those requirementsare based on management’s judgment,
  • 545. experience, and level of risk aversion.By accepting projects with longerpaybacks, management accepts more risk.The further out an investment’s payback,the more uncertain and risky it is. Theconcept is similar to the measure bondinvestors use, duration. The longer it takesan investor to recover half of his or herbond investment, the riskier it is.Payback period criteria are desirablebecause they are easy to calculate, use,and understand. However, they ignore thetiming of cash flows, and accordingly, thetime value of money. Projects with vastlydifferent cash flows can have the samepayback period. For example, a researchproject that repays a $100,000 investmentevenly in $33,333 installments over threeyears has the same three-year payback as
  • 546. the single $100,000 return received at theend of three years.Another shortcoming of using payback isthat it ignores the cash flows received afterthe payback. What if the $100,000 researchproject with a three-year payback continuedto churn out a stream of royalties forever asa result of a new invention? Clearly it wouldbe worth much more than a project that hada one-time payout of $100,000 in the thirdyear of the invention’s life.Net Present Value Methods. The samemethod used for valuing the cash flows ofbonds and stocks is also used to valueprojects. It is the most accurate and mosttheoretically correct method.The further in the future a dollar is received,the greater the uncertainty that it will be
  • 547. received (risk) and the greater the loss ofopportunity to use those funds (opportunitycosts). Accordingly, cash flows received inthe future will be discounted more steeplydepending on the riskiness of the project.NPV = Cash to Be Received × (1 +Discount Rate) Number of Periods (ascalculated in tables in Appendix or by usingbusiness calculators and computers)The ways in which a corporation wishes tofund itself are “financing” decisionsindependent of “investment” decisions. Aglaring non-MBA mistake in evaluatingprojects is to use a discount factor equal tothe cost of borrowing for the corporation asa whole. In 1999 stable corporations couldborrow money at the prime interest rate of7 to 8 percent. The individual projects thatbusinesses may want to invest in are not as
  • 548. stable. Accordingly, financial managersmust use a discount rate commensuratewith the risk of the particular project.In the Quaker Oats factory example fromthe QA chapter the cash flows looked asfollows:10% DiscountThe NPV method says that the projectreturned $32,343 in excess of the requiredrate of return for a project with that level ofrisk. Projects that have NPVs of $0 are alsoacceptable because they return therequired rate. Those below zero are flatly
  • 549. rejected.NPV has many advantages. It is flexible inmaking calculations that are useful incomparing different projects.Riskiness of Projects. In calculating theNPV an analyst can use different discountrates. For example, if he or she consideredthe profits from Quaker Oats’ new oatmealfilling equipment more risky, a 15 percentor 20 percent discount rate would value theproject at $21,019 or $11,217 respectively.Unequal Lives of Projects. An analyst doeshave the ability to value cash over manyyears by using different discount factorsbased on the risk-adjusted discount rate.The Quaker project could be comparedwith many other projects with cash flows ofone year, ten years, or unlimited. Thediscount factor can be used to discount all
  • 550. cash flows to their present value forcomparison.Scale Differences in the Size of Projects’Cash Flows. The ability of the NPV methodto discount cash at different amounts yieldsa “net” present value that is comparableamong different-sized projects. Thediscount factor also values the cash flow atany time in the future.Since capital needs to be rationed, what isan MBA to do if he or she needs tochoose? NPV tells you the best projects,but not the best group of projects. Theprofitability index (PI) can be of help. ThePI divides the NPV of the future cash flowsby the initial investment. For example, theQuaker project has an index of 1.317.
  • 551. In situations where money is unlimited, allPis above 1.00 would be accepted. Allprojects with a return over the risk-adjustedrate are attractive. With constrainedresources, only the investmentopportunities with the highest PI arechosen so that the group of investmentsmay yield the highest NPV for theshareholders.In those cases, it is up to the MBA analystto try different combinations of the bestprojects using NPVs and Pis as guides toget the highest possible NPV for the entire
  • 552. group.Business Financing DecisionsA large number of MBAs devote their livesto finding the financing for the capital needsof businesses. The goal of corporatefinance is to raise sufficient capital at theleast cost for the level of risk thatmanagement is willing to live with. The riskis that a business will not be able to serviceits debt and will be forced into bankruptcy.There are five basic ways of financing acompany’s needs:Receive Credit from SuppliersObtain Lease FinancingObtain Bank LoansIssue Bonds
  • 553. Issue StockSupplier Credit. Supplier credit is theeasiest way that companies obtainfinancing. Companies buy goods andservices and have anywhere from sevendays to a year to pay their bills. Whencompanies need more credit fromsuppliers, financial managers negotiatelonger credit terms or larger credit lines.Cash managers can also stretch theirpayables to vendors by paying them late. Inthe case of Federated and Allieddepartment stores in 1990, vendors refusedto extend them additional credit. Thecombination of creditors and debt holdersforced the company into bankruptcy.
  • 554. Lease Financing. Instead of buyingequipment, many companies choose tolease equipment. This is a form offinancing. Automobiles, computers, andheavy machinery can be financed for shortperiods or for longer periods. If the lease isfor a shorter period, it is called anoperating lease. At the end of the lease theproperty is still useful and is returned to thefinance company. This is the case with two-year car leases.Long-term leases are, in substance, waysof financing a purchase, rather than buyingthe temporary services of a piece ofequipment. Such long-term leases arecalled capital leases. The useful life of theleased equipment is used up by the lessee,and at the end of the lease the equipmentusually stays with the lessee for a bargain
  • 555. purchase price like $1. The accountantshave specific rules that deal with thedifferent kinds of leasing arrangements. Forcapital leases, the leased assets and thefinancing liability are recorded on theleasing company’s books as though thecompany had bought the equipmentoutright.Bank Financing. The next level of financinginvolves banks. Banks can loan money forlong-term or short periods of time. If acompany has a credit line or revolver with abank, it draws down and pays back up toset limits of credit as cash is needed andgenerated by the business. The credit isoften secured by the assets of the firm. If abusiness runs into trouble, it may not beable to pay the bank and go into
  • 556. bankruptcy. The once mighty Olympia &York real estate investment firm declaredbankruptcy in 1992 when bankers refusedto extend its owners, the Reichmannbrothers, any more credit for flounderingreal estate projects.Bond Issuance. Bonds have fixed interestrate contractual payments and a principalmaturity. The risk to the firm’s ownerscomes if they cannot be serviced. In 1990the Southland Corporation (7-Elevenstores) defaulted on its bond payment andIto-Yokado Corporation, the majoritybondholder, exchanged its bonds for theownership of the company and ousted theThompson family from the company theyhad founded.
  • 557. The After-Tax Cost of Borrowing. Interestpayments for borrowing from vendors,bankers, or bondholders are tax-deductible,while dividends to shareholders are not.The after-tax cost of borrowing is theinterest cost less the tax benefit.After-Tax Cost of Borrowing = BorrowingRate × (1 Tax Rate)In 1999, the Caterpillar bond used in theearlier example continual to pay 8 percentinterest on the issue maturing in 2001. In1999 Caterpillar’s corporate tax rate wasprojected at 34 percent. By deducting theinterest expense on the tax returns, thecompany received, in effect, a 34 percentdiscount on its borrowing. The after-tax ratewas 5.28 percent (8% × (1 .34)).
  • 558. As you learned in the Accounting chapter,dividends are not tax-deductible, butinterest payments are. That difference is anincentive for businesses to borrow ratherthan issue stock and pay dividends. Thisphenomenon is called a tax shield forborrowing. In the leveraged buyout binge ofthe 1980s, the tax shield was a spur toborrow huge amounts, such as the $26.4billion Kohlberg Kravis Roberts borrowed tobuy RJR Nabisco in 1989. That year thegovernment subsidized this venture to thetune of approximately $800 million (26.4 ×10% × 30%). Not surprisingly, manytaxpayers favor eliminating or restricting thetax subsidy for interest expenses.Stock Issues. Stock issues havenoncontractual, non-tax deductible dividend
  • 559. payments. Stock represents an ownershipinterest in the business and in all of itsassets. If additional shares of stock areissued to raise cash, this is done at theexpense of the current shareholders’ownership interest. New shareholdersshare their ownership interest equally on aper-share basis with the currentshareholders. That is why analysts say thatthe new shares dilute the interest ofexisting shareholders.There are several markets available to sellnew stock issues: the New York StockExchange (NYSE), the less importantAmerican Stock Exchange (AMEX), andthe emerging National Association ofSecurities Dealers Automated QuotationsSystem (NASDAQ). When a stock is notlisted on an exchange, but is publicly
  • 560. traded, it is traded Over the Counter (OTC).If a company’s shares are not publiclytraded, the company is said to be privatelyheld.Financial advisors called investmentbankers assist in the sale of new shares incompanies. Noted investment bankerssuch as Salomon Smith Barney; GoldmanSachs Group; BT Alex Brown; and MerrillLynch, employing many MBAs, work onthese initial public offerings (IPOs) for largefees. These I-bankers assist in thepreparation of the selling document, calledthe prospectus. The prospectus outlinesthe issuer’s history and business plans.The Securities Act of 1933 governs thedisclosures required in this document.The Financing Mix’s Risk and Reward. Thefinancing decisions in a corporation revolve
  • 561. around what is the best mix of debt andequity. That mix is called a company’scapital structure policy. When managersmake large changes in the debt-to-equitymix, they call it restructuring.Theoretically, there is an optimal mix ofdebt and stock; however, there are nomagic MBA formulas to establish thatperfect ratio. MBAs can look to whatworked in the past and to the mix ofsuccessful competitors. If the industry iscyclical, lighter debt loads are preferable inorder to survive downturns. Good financialmanagers don’t decide on a financing planand forget it. Capital structures are dynamic. Decisions to shift the balance from equityto debt and back again should becontinually reviewed to make sure thecapital structure is appropriate at any given
  • 562. point in time.Although there are no handy MBA formulasto solve once and for all the debt versusequity conundrum, there is a useful MBAacronym, FRICTO, whose initials stand fora useful checklist in sorting out capitalstructure issues.Flexibility. How much financial flexibilitydoes management need to meetunforeseen events, such as newcompetitors or lawsuits? For example, DowCorning never planned for the breastimplant litigation that crippled the company.Risk. How much risk can management livewith to meet foreseen events, such asdownturns in the business cycle, strikes,and material shortages? Toy companiesare known to produce hot toys that turncold. Savvy managers should plan for the
  • 563. eventual sales dropoff by providing enoughfinancial flexibility to survive the downturn.Accordingly, most toy companies have lowdebt-to-equity ratios.Income. What level of interest or dividendpayments can earnings support? Financialmanagers are required to forecast theresults of operations to determine cashflows. Using those forecasts, and thedegree of confidence a manager has in hisor her projections, he or she can determinewhat level of payments the company canmake.Control. How much stock ownership doesmanagement want to share with outsideinvestors? Many family business ownersare leery of letting an outsider even knowtheir income, let alone have a vote.
  • 564. Timing. Does the debt market offer veryattractive rates? Has the market overvaluedthe firm’s shares in the opinion ofmanagement? If so, then it makes sense tosell shares to the public. Conversely, if thestock is too cheap then it is better to buyback shares from the public. After the crashof 1987, many firms took the opportunity tobuy back their own shares. By reducing thenumber of shares outstanding, their shareof debt financing grew as a portion of theircapital structures.In 1991 investors could not buy enoughbiotechnology stock. They paid very highprices for even questionable start-ups.Smart managers tapped that market, andsold shares to the eager public at highprices. In 1992, the days of easy moneyended when biotech fell out of favor with
  • 565. investors. The same story repeated itselffor Internet companies in 1995 and theenthusiasm continued into 1999. Acompany’s capital structure should bedynamic to take advantage of marketconditions.Other. Many other factors affect the pathsmanagers take. At times, a company justcan’t find a bank to lend money, forcing anequity choice. In other circumstancesinterest rates are just unaffordable, forcingan equity choice. The reasons for capitalstructure decisions are many.Key to financial structure is the discussionof ratios. In the Accounting chapter, Iexplained the concept of financial leverage.Companies that maintain high levels ofdebt and little equity leverage their earnings
  • 566. for shareholders if there are profits. Thereare simply fewer shares to divide incomeby, yielding higher earnings per share.Conversely, highly leveraged firms wipe outthe entire value of their equity whenearnings falter and interest payments eatup all the profits.Managers of highly leveraged firms mustdecide whether it is worthwhile to riskbankruptcy if their cash flow projectionsdon’t pan out in order to offer high returnsto their shareholders. The Thompson familyguessed wrong with Southland, while thehappy and rich management of ARAServices, the food service company,calculated correctly in their leveragedbuyout in 1984. Who knows? Maybe if theThompson had used FRICTO, they mighthave avoided their losses!
  • 567. The market value of shares already issuedis also related to the risk of a firm’s capitalstructure. If investors believe that debtlevels are excessive, then they will pay lessfor the company’s shares, since the debtpayments could put earnings in jeopardy.Investors will also discount the marketvalue of a company’s debt for risk. Thatwas the case in the early 1990s withleveraged companies such as Black &Decker, and RJR Nabisco. Many investorsfelt uncomfortable with the riskiness of theircapital structures and avoided both thedebt and equity of these highly leveragedcompanies.Modigliani and Miller, a famous duo fromMBA academia, created a series of“propositions” that discussed how debtaffects the values of firms. In 1958, Franco
  • 568. Modigliani and Merton Miller did theirpioneering work on the effect of debtfinancing with and without a tax advantage.In a perfect world, the more debt the better.The value of the firm increases with higherdebt levels. However, in the real world, asseen in the previous paragraph, investorsdo consider the risk of insolvency in theirvaluations of both debt and equity.To summarize, the higher the percentageof debt to total capital, the higher acompany’s value, to a point. At the pointwhere the risk of bankruptcy becomessignificant, values fall. The cost of financingdecreases as a company adds lower-costtax-shielded debt to displace the higherreturns required by equity investors. Butlike stockholders, debt holders becomenervous at a certain point and require
  • 569. higher rates of return to compensate themfor their risk. Study the two graphs on page219 that illustrate the workings of capitalstructure.A Detailed Capital Structure DecisionExample. Although choosing the optimalcapital structure is difficult, financialmanagers try to put together somenumbers to make choices. If you arecurious about the details and want tograduate from the Ten-Day MBA “cumlaude,” read on. If not, just skip to the nextsection. Making capital structure decisionsinvolves a two-step process:1.Calculate the WACC.2.Value the Free Cash Flows of the company, the value of the firm.
  • 570. The first step is to calculate the weightedaverage cost of capital (WACC) of theentire firm by using the following formulaand calculating a number of variables. Thecost of equity (ke) is the most difficult. t = tax rateK d = cost of debtK e = cost of equityReview the formula. Notice that the WACCuses the market values of debt and equity.The market is the true measure of howcurrent bondholders and shareholdersvalue their investments. The cost of debt
  • 571. can be obtained from the company’streasury department or can be found in thefootnotes of the financial statements. Ittakes large boosts in debt financing tochange the cost of debt. However, the costof equity is a bit more complex to figure out.The cost of equity heavily depends on theleverage of the firm. Because leveragemeans risk, we can use beta from thecapital asset pricing model (CAPM). TheCAPM helps calculate the required returnon equity under different leveragescenarios.K e = R f + (K m R f ) × Beta(K m R f ) = Risk PremiumThe risk measure, Beta, changes accordingto the risk of leverage. Financial MBAs takethe current levered beta and unlever it to ano-debt, unlevered state (Step A), then
  • 572. lever it back up to any hypothetical capitalstructure (Step B).Optimal Capital StructureThe Cost of CapitalCapital=Debt + Equity K e= Cost of Equity K d= Cost of Debt K wacc = the WeightedAverage Cost of Capital
  • 573. Optimal Capital StructureThe Value of the Firm andthe Weighted Average Cost of CapitalCapital = Debt + Equity
  • 574. l = levered structure with debtu = unlevered structure without debtTo illustrate: The treasurer of Leverco, Inc.wants to decide whether to choose a 0percent, 25 percent, or 50 percent debtcapital structure. In order to do so he haslaid out the facts and calculations in thefollowing columns of numbers. Theconclusion is that Leverco should have a50 percent debt/50 percent equity capitalstructure. That’s the structure that
  • 575. maximizes the value of the firm whileminimizing the WACC.The same calculations demonstrated inLeverco’s case were used to derive the twotheoretical graphs of the “Optimal CapitalStructure.” The first is the calculation of theweighted average cost of capital. Thesecond graph, using the lowest WACCshown, describes the maximum value ofthe firm. If you wish, you can try torecompute the calculations that are notedwith an asterisk (*). These are the samecomputations that MBAs throughout theworld use for capital structure decisions.Dividend Policy. Financial managers mustdecide how much of a firm’s profits shouldbe paid out as dividends and mustdetermine the size of dividends per share.
  • 576. This is called dividend policy.To guide them in their policies financialmanagers use at least two measures—dividend yields and dividend payout ratios.The market plays a big role in determiningthe dividend yield since it is derived bydividing the annual dividend payment bythe current share price. Dividends may alsobe paid out as a certain percentage ofearnings, called the dividend payout ratio.Capital Structure Decision CalculationLeverco, Inc.Scenarios
  • 577. Adapted from “An Introduction to DebtPolicy and Value,” Case UVA-F-811.Copyright © 1989 by the Darden GraduateBusiness School Foundation,Charlottesville, Virginia.Dividends are extremely important becausethey show clearly the cash-generatingability of the firm. Many analysts valuecompanies based on the dividend cashflows. You saw that valuation method withthe Dividend Growth Model earlier in thischapter.Investors love stable, steadily growingdividends, and hate any cuts. Therefore,
  • 578. managers try to avoid swings in dividendpayouts at all costs. If an MBAmiscalculates the ability of the company tomaintain a dividend, his or her job will be inreal jeopardy.There are five questions that astute MBAsought to mull over as they formulate apolicy that may directly affect their careers.Can the company do a better job byinvesting its earnings back into the firmthan investors could by investingelsewhere? If a company is growing andhas many exciting investmentopportunities, dividends should be smalland earnings should be used internally. In1999 Wal-Mart paid a puny $.31 dividendper share against $2.50 in earnings, butinvestors were happy because thecompany was busy investing in many new
  • 579. and profitable stores.Who is your stockholder? Do widows andorphans depend on your dividends for theirincomes? This is the case with utilitystocks, but not with start-up Internetcompanies.What will stockholders’ reaction be to anychanges in dividend payments? Changes individend payments are a very powerfulsignal to investors. Investors react violentlyto any cuts in dividends, since they signalthat the company is in trouble. Increasesare not such a big deal. More often thannot, dividend increases are expected andgreeted with little fanfare. Increases individends show management’s confidencethat the business’s earnings are strongenough over the long-term to sustain anincreased payout.
  • 580. What is the degree of financial leverage ofthe company? To ensure that dividends willnot be interrupted, companies should seeto it that they can comfortably pay thedividends investors expect and demand.What is the growth strategy of thecompany? Growth companies usually paylittle to no dividends. They need cash tofinance their own growth. Biotechnologycompanies, for example, retain all theircash to support long-term research needs.If a company is strapped for cash and yetstill wants to make investors happy, it canpay a stock dividend. This is a dividend thatthe company pays in shares of thecompany, not cash. Such dividends usuallyrange from 2 to 5 percent of shares owned.For example, if you were to own onehundred shares you would receive two to
  • 581. five new shares. Investors end up with agreater number of shares, but since allshareholders receive the same percentageshare dividend, their percentage ownershipof the firm remains the same.If a stock price is high, the company canalso have a stock split, giving two or threeshares for every share owned. It makes thestock more affordable and makes investorshappy, but the percentage ownershipremains the same. Mergers and AcquisitionsMergers and acquisitions (M&A) is one ofthe most exciting areas of finance. Thesame investment bankers who helpcompanies raise money also helpcompanies spend it. Many highly paidMBAs work in this field. “Strategic” reasonsand methods for M&A are covered in the
  • 582. Strategy chapter. This chapter will coverthe legitimate financial reasons for mergersand acquisitions.Diversify the companyMany companies attempt to lower risk byowning other businesses. Philip Morrisbought Kraft, General Foods, and MillerBrewing because it wanted to diversify.Tobacco usage was declining, lawsuitsloomed, and new regulation limitingadvertising was pending.Improve Sales and EarningsProcter & Gamble, the leader in soaps,detergents, and paper products, decided toexpand sales and earnings by buyingNorwich Easton (Pepto-Bismol),Richardson-Vicks, Noxell, and HawaiianPunch. Their brand management expertiseserved them well in enhancing the values
  • 583. of these acquisitions.Purchase an Undervalued CompanyBased on market conditions, corporationscan sometimes buy companies at abargain. Companies may also be a bargainif investors do not recognize the potential ofvaluable assets on the books. TurnerBroadcasting bought MGM/United Artists in1986, because MGM had an extensivemovie library of classics that Turner feltwas undervalued and not fully exploited.Lower Operating CostsWhen companies merge many cost savingsare possible. With the absorption of acompany, some of the acquired company’scorporate overhead expenses can be cut.In manufacturing mergers, factories canproduce larger quantities more efficiently.
  • 584. In the 1990s, many companies wereformed to consolidate fragmentedindustries by “rolling up” many mom-and-pop outfits, in hopes of achievingefficiencies. Office supply businesses,veterinary practices, and car dealershipswere rolled up.Types of AcquisitionsIf two companies decide to join forces tobecome one company, this is called amerger. When Sperry and Burroughsmerged in 1986, the merged entity wasnamed Unisys.If one company buys another company it iscalled an acquisition. If both parties agreeto the purchase, it is called a friendlyacquisition; if not, it is called a hostiletakeover.
  • 585. Smaller companies that are attractivetakeover candidates often agree to bepurchased in friendly takeovers. In 1989Procter & Gamble made a friendlypurchase of Noxell, the maker of CoverGirl and Clarion cosmetics. Both saw theadvantages of the two marketingcompanies joining forces.In other cases, the purchase can be nasty.In 1984, T. Boone Pickens tried to buyPhillips Petroleum in an unsuccessfulhostile takeover. The management ofPhillips was so opposed to the idea that in1985 it borrowed $4.5 billion to buy back 47percent of its common stock. This thwartedPickens’s efforts because it borrowedagainst the same assets that he wasplanning to mortgage.
  • 586. The fourth type of acquisition that I havementioned several times already in thischapter is the leveraged buyout (LBO). Inthe 1980s, there were many lenders whowere willing to loan money to takeoverartists. In the same way that a mortgagecompany makes a loan to a home buyer fora down payment of only 5 percent, banks,insurance companies, and bond investorslent money to these financiers to buycompanies. The company that emergesfrom a leveraged buyout carries a highlevel of debt on which it must pay interestand principal.The Valuation ProcessTo engage in M&A, you must assess thevalue of the targets. Cash flow is the mainconsideration. A business’s cash flows arethe result of operations, investing, and
  • 587. financing activities (the same activities thatthe accountant’s Statement of Cash Flowsdescribes). In the Accounting chapter, Iused the example of tiny Bob’s Market. Byadding a few zeroes to the numbers, itcould be Safeway, Kroger, or A&P.Because you are already familiar withBob’s Market, this section will continue withthis example.There are five steps involved in calculatingand evaluating a business’s cash flows:1.Analyze operating activities.- Forecast the Income Statement; sales, cost of goods sold, selling, general and administration expensesAnalyze the capital requirements of thefirm.
  • 588. - Determine the corporate working capital requirements.There are many techniques or approachesthat MBAs use to value firms. With all theflair a marketer displays in putting togethera marketing strategy, finance jocks showtheir stuff in M&A valuations. The followingis one popular method used by many in thefinancial community.Bob’s Market Income Statement for theYear Ending December 31, 2000 (inthousands)
  • 589. 1. Analyze operating activities and thefirm’s capital spending requirements.The first thing is to forecast sales andcalculate the gross margins on sales andother operating expenses. But financialanalysts must do more than just look atnumbers. They must also review theindustry, the competition, the markets forraw materials, and management’s plans torun and grow the business. All thesefactors will affect the cash flow of business.Discussions with Bob, his accountant, andhis assistant manager revealed that thebusiness is healthy and they expect salesto grow by 10 percent a year over a four-year period and then stabilize. They areconfident that they will maintain a grossmargin of 25 percent or a variable 75percent cost of sales. They also believe
  • 590. that their SG&A expenses will remain asteady variable 24 percent of sales. Thedepreciation for equipment, which does notcost cash, can be added back, but Bobbelieves that he will be upgrading the storeeach year by reinvesting the $3,000 in newstore fixtures. With that information, thecash flow forecast would look as follows:Cash Flow Projections (in thousands)2. Analyze the investments necessary toreplace and to buy new property, plant, and
  • 591. equipment.Don’t be shy. Consult with the engineers,purchasing department, and theaccountants to get a good estimate of costsand useful lives.3. Determine the working capital needs ofthe business.Businesses need cash to operate. Thelevel of working capital is most often afunction of the volume of sales. The moresales that are generated the greater thecash needs for making change at the cashregisters and purchasing inventory. Thisneed is balanced somewhat by the creditthat vendors increasingly extend as themarket’s purchases from them grow involume. This is a very important part of theprocess; failing to consider the workingcapital needs could result in a cash
  • 592. squeeze.When we look back at the balance sheet ofBob’s Market, we see that Bob had$115,000 in current assets and $87,000 incurrent liabilities. That is a net workingcapital position of $28,000 (115 87).Bob says that every week he needs 28cents for every dollar of sales($28,000/[$5,200,000 annual sales/52weeks per year]). That covers his cashneeds for inventory and register moneyoffset by the additional financing extendedby his grocery vendors. Added to thevaluation calculation, the cash flowprojection would look as follows:Cash Flow Projection (in thousands)
  • 593. 4. Determine the terminal value of the firm.A business is presumed to be a goingconcern that will continue to operateindefinitely into the future. By valuing thecash flow to a certain point in time, you areignoring ongoing value. That is why at theend of the financial projection, a terminalvalue must be calculated and added to thecash flow valuation.At Bob’s Market the fourth year’s cash flowwas $73,000. If that cash is forecasted tobe the same year after year, you could usethe same valuation method that is used tovalue a perpetuity.
  • 594. The proper discount factor to use in thiscase is the weighted average cost of capital(WACC). We use WACC because the freecash flow of the company is available topay interest on debt and to pay dividends toequity holders. Therefore the properdiscount factor takes into account the firm’sentire capital structure, its debt and equity.Bob’s Market’s capital structure is veryconservative. Its balance sheet lists only$10,000 of debt and $45,000 of equity. Itsdebt carries an interest rate of 10 percent.The cost of equity can be calculated usingthe Capital Asset Pricing Model. Using along-term risk-free treasury rate of 8percent, the risk premium of 7.4 percent,and a .85 beta representing the lower risk
  • 595. of a low-debt grocery store, the cost ofequity is 14.3 percent.K e = R f + (K m R f ) Beta14.3% = 8% + (7.4%) .85Plugging the cost of equity into the WACCequation, the firm’s weighted average costof capital is 13 percent.Putting it all together in a valuation, theterminal value cash flow calculation wouldbe:
  • 596. 5. Calculate the NPV of those cash flows tocalculate the firm’s value.Add the terminal value to the present valueof the first three years’ projected cashflows, and the entire value of the firm canbe calculated as follows:Net Present Valuationof Free Cash Flows (in thousands)
  • 597. That’s it! The grocery store is worth$485,000. After subtracting the $10,000 indebts, the net equity that Bob owns is worth$475,000. That’s how the MBAs valuecompanies large and small. Yes, it’s a bittedious, but mathematically not difficult tocalculate. By keeping M&A a mysteriousprocess, MBAs can charge more for theirM&A services. Now you have the insidestory.Additional Things MBAs Include in TheirValuationsThe valuation of Bob’s Market assumesthat the grocery store will be operated asBob said it would. MBAs sometimes havedifferent ideas. Companies being analyzedfor potential acquisition are just like meat ina butcher shop—cut, sliced, and ground upas necessary. Analysts investigate the
  • 598. company from all angles. MBAs look at anyopportunity to improve operations, lowerexpenses, and increase cash flow. Theyconsider the sale of assets. The process iscolored by the type of acquisition it is:merger, friendly, hostile, or leveraged. If thecompany is being taken over by a newmanagement, then many changes arepossible and likely. If the purchase is madewith a great deal of debt, the new ownerswill want to increase cash flow and sellassets as soon as possible to pay off thedebt incurred in purchasing the company. Asampling of things new owners will look forin these situations are:
  • 599. - Wage Concessions, Break Labor Unions- Layoffs- Lower Production Costs- Reduce Working Capital Needs- Lower Inventory
  • 600. - Lower Receivables- Increase PayablesThe MBA Touch: Asking “What If?” All thesteps outlined can be investigated andplugged into mathematical formulas andspreadsheets. Analysts have to make manyinformed guesses. The real contribution anMBA can make to the process is not onlyan accurate evaluation of specific companyinformation, but an experienced evaluationof the external factors that may affect thecash flows forecasted. How would achange in product costs affect theforecasted cash flows? How could thecompetitive environment in the industryaffect sales? What if?A proper MBA forecast of cash flowsincludes variations or “sensitivities” of keyassumptions, so that decision makers can
  • 601. assess the risk inherent in the cash flowsthey are forecasting. The use of aspreadsheet is imperative and its “Data-Table” function is the MBA tool to performvariation analysis. If you’re not familiar withit, consider yourself computer illiterate.In the airline industry, for instance, fuelprices, fares, and passenger load factorscan produce swings in cash flows.Variations in key assumptions such asthese three items dramatically changevaluations and cash flows. In a leveragedbuyout, owners are counting on projectedcash flows to pay interest on the debt theycarry. If they are caught short of cash,companies go into bankruptcy. Carl Icahnwas caught short, and his TWA was forcedto temporarily operate under the protectionof bankruptcy in 1992 and has since
  • 602. recovered.Making a BidMBA calculations and forecasts are fineand dandy, but often they are ignored.Sometimes the thrill of the hunt overcomesbuyers, and they act like bidders in the heatof an art auction. Instead of a net presentvalue cash flow valuation, bidders usesimpler rule-of-thumb methods, a multipleof earnings or a multiple of sales. Inleveraged buyouts, the bid often simplyrepresents the maximum amount offinancing the acquisitor can obtain, or themaximum debt the targeted company’scash flow can carry. People differ, andaccordingly, they have different motivationsand methods in their M&A quests.
  • 603. Financial OverviewSimply stated, there are two main functionsin the financial world: buying and selling.Businesses require funding, therefore theyeither sell equity shares in their companies(stocks), or fixed interest paymentssecurities (bonds). The investmentcommunity values these securities andbuys and sells them.The theoretical basis for financial analysisis the risk/reward equation, in which higherrisks are associated with higher returns.Returns are calculated by determining theamount and the timing of cash flows.The guiding principle of financialmanagement is to maximize the firm’svalue by financing cash needs at the leastcost possible, at a level of risk thatmanagement can live with.
  • 604. Key Finance TakeawaysPresent Value—The value of a dollarreceived in the future is less than a dollaron hand today. There is a time value ofmoney.Beta—A measure of risk inherent in asecurity or a portfolio of securities as itreacts to general market movementsThe Efficient Frontier—The graph depictingthe highest portfolio returns for a given risklevelThe Capital Asset Pricing Model —K e = Rf + (K m R f ) BetaDuration—The time it takes for a bond topay back half of an investor’s investmentBond Value Fluctuations—If market interestrates go up, bond values go down, and viceversa.
  • 605. The Dividend Growth Model—Value = D/(kg)Call Option—The right to purchase anasset at a fixed price for a limited amount oftimePut Option—The right to sell an asset at afixed price for a limited amount of timeThe After-Tax Cost of Borrowing—After-Tax Rate = Borrowing Rate × (1 tax rate)Capital Structure—The mix of debt andequity of a companyFRICTO—Flexibility, Risk, Income, Control,Timing, and Other matters, the checklist tobe considered in making capital structuredecisionsThe Optimal Capital Structure—One thatminimizes the weighted average cost ofcapital and maximizes the value of the firm
  • 606. Day 7 Operations Operations TopicsThe History of Operations ResearchThe Problem Solving FrameworkFlow DiagramsLinear ProgrammingGantt ChartsCritical Path MethodQueuing TheoryInventoriesEconomic Order QuantitiesMaterial Requirements PlanningQuality
  • 607. Information TechnologyOperations is the only MBA subject thatconcerns itself with actually makingproducts and providing services—theultimate purpose of business. That is theline Production and OperationsManagement (POM) professors delivereach year to incoming MBAs. It must fall ondeaf ears, since most MBAs go intofinance, marketing, and consulting. It maybe that recruiters feel MBAs are notsufficiently trained to be worth the highsalaries paid in their plants and factories.They may also believe that MBAs are bestkept at headquarters with their computers,cigars, and Waterman pens. From myinterviews with recruiters and students, lackof interest on both sides is responsible for
  • 608. the lack of operational-bound MBAs.Operational subjects are not all engineeringand numbers. POM classes also have ahumanistic side. The technical orquantitative approach presents studentswith a variety of mathematical tools withwhich to attack operational problems in aclinical fashion. The humanistic approachteaches students to look at operationalproblems from a worker’s perspective aswell. Clearly many business solutions lie inemployee motivation. The Operations History LessonStudies on methods to improve theproduction of goods and services havebeen conducted since the beginning of thecentury. Academics believed that if they
  • 609. only researched closely enough howbusinesses worked, they would stumble onthat magic formula that would result in totalefficiency. Much of that pioneering researchwas done on the factory floor. Becausetheir names and theories are frequentlymentioned in articles and MBAconversation, you had better add them toyour business vocabulary.Frederick TaylorFrederick W. Taylor, considered the “fatherof scientific management,” developed hisscientific management theories in the late1800s and the early 1900s. He studied,measured, and documented the behavior ofsteel workers. He showed that by breakingdown a complex task into smallercomponent tasks, through a process thathe called job fractionalization, each smaller
  • 610. task could be studied to find the mostefficient way of accomplishing it. Bysuccessfully combining the most efficientelements, the best production methodscould be adopted. Taylor performedcountless time and motion studies using astopwatch to find the “one right way” ofdoing things. In Taylor’s opinion, it was in aworker’s nature to “soldier,” meaning toslack off. Therefore, it was management’sresponsibility to control the workplace andto force lazy workers to be efficient in spiteof themselves.Frank and Lillian GilbrethThe Gilbreths also studied ways to achievepeak factory efficiency. Their investigationsled them to the development of a spectrumof seventeen types of body movements thatcovered the range of a factory worker’s
  • 611. motion. Each motion was called a therblig.Like Taylor, the Gilbreths broke a complextask into its component parts. Byunderstanding each element, one couldsimplify a job through the elimination ofwasteful motion. Streamlining the task to itsessential therbligs was key. Lillian wroteabout her attempts to streamline the choresof parenting a family of twelve children in ahumorous book entitled Cheaper by theDozen. In 1984 the U.S. Postal Servicecommemorated her contribution tobusiness and literature with a forty-centstamp.Elton MayoElton Mayo is considered the father of thehuman relations movement of productionmanagement. In his search for efficiency,Mayo believed that the emotional state of
  • 612. workers is just as important as finding theright combination of movements.Mayo’s claim to fame came as a result of aseries of experiments he conducted in 1927at the Hawthorne Works of the WesternElectric Company. In those studies, hevaried the intensity of light on the shop floorin an effort to discover the degree oflighting that would result in the greatestproductivity. He found that regardless ofchanges in lighting, worker productivityincreased. Knowing that they were thesubject of a study made the workers actdifferently. That phenomenon came to beknown as the Hawthorne Effect. Puzzled bythe results, Mayo interviewed the workersand found that they had performed betterbecause during the experiment they werebeing treated better by their supervisors.