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Selected material from Fundamentals of Corporate Finance Third Edition Richard A. Brealey Bank of England and London Business School Stewart C. Myers Sloan School of Management Massachusetts Institute of Technology Alan J. Marcus Wallace E. Carroll School of Management Boston College with additional material from Fundamentals of Corporate Finance, Alternate Fifth Edition Essentials of Corporate Finance, Second Edition Stephen A. Ross, Massachusetts Institute of Technology Randolph W. Westerfield, University of Southern California Bradford D. Jordan, University of Kentucky UNIVERSITY OF PHOENIX Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St. Louis Bangkok Bogotá Caracas Lisbon London Madrid Mexico City Milan New Delhi Seoul Singapore Sydney Taipei Toronto Selected material from FUNDAMENTALS OF CORPORATE FINANCE, Third Edition with additional material from FUNDAMENTALS OF CORPORATE FINANCE, Alternate Fifth Edition ESSENTIALS OF CORPORATE FINANCE, Second Edition Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a data base retrieval system, without prior written permission of the publisher. This book contains select material from: Fundamentals of Corporate Finance, Third Edition by Richard A. Brealey, Stewart C. Myers, and Alan J. Marcus. Copyright © 2001, 1999, 1995, by The McGraw-Hill Companies, Inc. Fundamentals of Corporate Finance, Alternate Fifth Edition by Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan. Copyright © 2000, 1998, 1995, 1993, 1991 by The McGraw-Hill Companies, Inc. Essentials of Corporate Finance, Second Edition by Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan. Copyright © 1999 by The McGraw-Hill Companies, Inc. Previous edition © 1996 by Richard D. Irwin, a Times Mirror Higher Education Group, Inc. company. All reprinted with permission of the publisher. ISBN 0-07-553109-7 Sponsoring Editor: Christian Perlee Production Editor: Nina Meyer Contents 1 SECTION 1 How to Value Perpetuities 50 How to Value Annuities 51 Annuities Due 54 Future Value of an Annuity 57 The Firm and the Financial Manager 3 Organizing a Business 4 Sole Proprietorships 4 Partnerships 5 Corporations 5 Hybrid Forms of Business Organization 6 The Role of the Financial Manager 7 The Capital Budgeting Decision The Financing Decision 9 Inflation and the Time Value of Money 8 Effective Annual Interest Rates Financial Institutions and Markets Summary 10 Careers in Finance 13 15 Goals of the Corporation Financial Planning 17 Shareholders Want Managers to Maximize Market Value 17 Ethics and Management Objectives 19 Do Managers Really Maximize Firm Value? Snippets of History 25 Summary 21 Financial Planning Models Planners Beware 87 93 Pitfalls in Model Design 93 The Assumption in Percentage of Sales Models The Role of Financial Planning Models 95 33 34 External Financing and Growth 38 Multiple Cash Flows 86 Components of a Financial Planning Model An Example of a Planning Model 88 An Improved Model 89 Future Values and Compound Interest Finding the Interest Rate 82 Financial Planning Focuses on the Big Picture 83 Financial Planning Is Not Just Forecasting 84 Three Requirements for Effective Planning 84 Related Web Links 28 Key Terms 28 Quiz 28 Practice Problems 29 Solutions to Self-Test Questions 31 Present Values 77 81 What Is Financial Planning? 25 The Time Value of Money 67 69 Related Web Links 69 Key Terms 70 Quiz 70 Practice Problems 72 Challenge Problems 75 Solutions to Self-Test Questions Minicase 79 Financial Institutions 10 Financial Markets 11 Other Functions of Financial Markets and Institutions 12 Who Is the Financial Manager? 61 Real versus Nominal Cash Flows 61 Inflation and Interest Rates 63 Valuing Real Cash Payments 65 Real or Nominal? 67 Summary 44 46 Future Value of Multiple Cash Flows 46 Present Value of Multiple Cash Flows 49 Level Cash Flows: Perpetuities and Annuities 50 94 96 100 Related Web Links 101 Key Terms 101 Quiz 101 Practice Problems 102 Challenge Problems 106 Solutions to Self-Test Questions 106 iii IV CONTENTS 109 APPENDIX A Accounting and Finance The Balance Sheet Financial Ratios The Income Statement 117 Profits versus Cash Flow 118 115 The Statement of Cash Flows Accounting for Differences 119 121 134 The Du Pont System 145 Other Financial Ratios 146 Using Financial Ratios 147 Choosing a Benchmark 147 123 Corporate Tax 123 Personal Tax 125 Summary 133 Leverage Ratios 138 Liquidity Ratios 139 Efficiency Ratios 141 Profitability Ratios 143 112 Book Values and Market Values Taxes Financial Statement Analysis 111 Measuring Company Performance The Role of Financial Ratios 126 Related Web Links 127 Key Terms 127 Quiz 127 Practice Problems 128 Challenge Problem 131 Solutions to Self-Test Questions Summary Bank Loans 185 Commercial Paper 186 Secured Loans 186 Working Capital Management and Short-Term Planning 165 167 The Components of Working Capital 167 Working Capital and the Cash Conversion Cycle The Working Capital Trade-Off 171 The Cost of Bank Loans 168 Links between Long-Term and Short-Term Financing 172 Tracing Changes in Cash and Working Capital 175 Cash Budgeting 159 163 SECTION 2 Working Capital 151 153 Related Web Links 155 Key Terms 155 Quiz 155 Practice Problems 157 Challenge Problem 158 Solutions to Self-Test Questions Minicase 160 131 150 177 Forecast Sources of Cash 177 Forecast Uses of Cash 179 The Cash Balance 179 A Short-Term Financing Plan 180 Options for Short-Term Financing Evaluating the Plan 184 180 Sources of Short-Term Financing 187 Simple Interest 187 Discount Interest 188 Interest with Compensating Balances Summary 189 190 Related Web Links 191 Key Terms 191 Quiz 191 Practice Problems 192 Challenge Problem 194 Solutions to Self-Test Questions Minicase 197 195 Cash and Inventory Management Cash Collection, Disbursement, and Float 185 Float 203 Valuing Float 204 201 202 CONTENTS Managing Float 205 Credit Analysis Speeding Up Collections 206 Controlling Disbursements 209 Electronic Funds Transfer 210 Inventories and Cash Balances 211 Managing Inventories 212 Managing Inventories of Cash 215 Uncertain Cash Flows 216 Cash Management in the Largest Corporations Investing Idle Cash: The Money Market 218 Summary The Credit Decision 217 Bankruptcy 224 231 SECTION 3 Valuing Bonds 240 227 244 Related Web Links 245 Key Terms 245 Quiz 245 Practice Problems 246 Challenge Problems 248 Solutions to Self-Test Questions 249 Minicase 250 Book Values, Liquidation Values, and Market Values 283 256 Reading the Financial Pages Valuing Common Stocks 257 Bond Prices and Yields 259 How Bond Prices Vary with Interest Rates 260 Yield to Maturity versus Current Yield 261 Rate of Return 265 Interest Rate Risk 267 The Yield Curve 268 Nominal and Real Rates of Interest 268 Default Risk 270 Valuations in Corporate Bonds 273 Summary 273 Related Web Links 274 Key Terms 274 Quiz 274 Practice Problems 275 Challenge Problems 277 Solutions to Self-Test Questions Valuing Stocks 239 253 255 Bond Characteristics Collection Policy Summary 229 Credit Agreements 236 Bankruptcy Procedures 241 The Choice between Liquidation and Reorganization 242 Credit Management and Collection Terms of Sale 234 Credit Decisions with Repeat Orders 237 Some General Principles 238 219 Related Web Links 220 Key Terms 220 Quiz 220 Practice Problems 221 Challenge Problem 224 Solutions to Self-Test Questions 232 Financial Ratio Analysis 233 Numerical Credit Scoring 233 When to Stop Looking for Clues Simplifying the Dividend Discount Model 279 Stocks and the Stock Market Reading the Stock Market Listings 280 281 291 The Dividend Discount Model with No Growth 291 The Constant-Growth Dividend Discount Model 292 Estimating Expected Rates of Return 293 Nonconstant Growth 295 Growth Stocks and Income Stocks The Price-Earnings Ratio 298 What Do Earnings Mean? 298 Valuing Entire Businesses 301 Summary 277 287 Today’s Price and Tomorrow’s Price 287 The Dividend Discount Model 288 301 Related Web Links 302 Key Terms 302 Quiz 302 Practice Problems 303 Challenge Problems 306 Solutions to Self-Test Questions 307 296 V VI CONTENTS Introduction to Risk, Return, and the Opportunity Cost of Capital 311 Rates of Return: A Review 312 Market Indexes 314 The Historical Record 314 Using Historical Evidence to Estimate Today’s Cost of Capital 317 318 Variance and Standard Deviation 318 A Note on Calculating Variance 322 Measuring the Variation in Stock Returns 322 Net Present Value and Other Investment Criteria 341 343 A Comment on Risk and Present Value Valuing Long-Lived Projects 345 Other Investment Criteria 344 349 Internal Rate of Return 349 A Closer Look at the Rate of Return Rule 350 Calculating the Rate of Return for Long-Lived Projects 351 A Word of Caution 352 Payback 352 Book Rate of Return 355 Investment Criteria When Projects Interact Mutually Exclusive Projects 356 Investment Timing 357 Long- versus Short-Lived Equipment 359 Replacing an Old Machine 361 Mutually Exclusive Projects and the IRR Rule Other Pitfalls of the IRR Rule 363 Capital Rationing 365 Soft Rationing 365 Hard Rationing 366 Pitfalls of the Profitability Index Summary 331 Message 1: Some Risks Look Big and Dangerous but Really Are Diversifiable 331 Message 2: Market Risks Are Macro Risks 332 Message 3: Risk Can Be Measured 333 Summary 334 Related Web Links 334 Key Terms 334 Quiz 335 Practice Problems 336 Solutions to Self-Test Questions 338 Challenge Problems 373 Solutions to Self-Test Questions 373 339 SECTION 4 Net Present Value 324 Diversification 324 Asset versus Portfolio Risk 325 Market Risk versus Unique Risk 330 Thinking about Risk Seventy-Three Years of Capital Market History 313 Measuring Risk Risk and Diversification 367 Related Web Links 368 Key Terms 368 Quiz 368 Practice Problems 369 3667 Using Discounted Cash-Flow Analysis to Make Investment Decisions 377 Discount Cash Flows, Not Profits 379 Discount Incremental Cash Flows 381 Include All Indirect Effects 381 Forget Sunk Costs 382 Include Opportunity Costs 382 Recognize the Investment in Working Capital Beware of Allocated Overhead Costs 384 356 383 Discount Nominal Cash Flows by the Nominal Cost of Capital 385 Separate Investment and Financing Decisions Calculating Cash Flow 387 361 Capital Investment 387 Investment in Working Capital 387 Cash Flow from Operations 388 Example: Blooper Industries 390 Calculating Blooper’s Project Cash Flows 391 Calculating the NPV of Blooper’s Project 392 Further Notes and Wrinkles Arising from Blooper’s Project 393 Summary 397 Related Web Links Key Terms 398 Quiz 398 398 386 CONTENTS Practice Problems 200 Challenge Problems 402 Solutions to Spreadsheet Model Questions Solutions to Self-Test Questions 404 Minicase 405 403 Risk, Return, and Capital Budgeting Measuring Market Risk 408 Measuring Beta 409 Betas for MCI WorldCom and Exxon Portfolio Betas 412 Risk and Return Big Oil’s Weighted-Average Cost of Capital 420 The Cost of Capital 435 Geothermal’s Cost of Capital 436 450 When You Can and Can’t Use WACC 451 Some Common Mistakes 452 How Changing Capital Structure Affects Expected Returns 452 What Happens When the Corporate Tax Rate Is Not Zero 453 424 Flotation Costs and the Cost of Capital Summary 454 Related Web Links 455 Key Terms 455 Quiz 455 Practice Problems 456 Challenge Problems 458 Solutions to Self-Test Questions Minicase 459 Calculating the Weighted-Average Cost of Capital 438 458 463 SECTION 5 Project Analysis Real Oil Company WACCs 465 How Firms Organize the Investment Process Stage 1: The Capital Budget 467 Stage 2: Project Authorizations 467 Problems and Some Solutions 468 Some “What-If ” Questions 469 Sensitivity Analysis 469 Scenario Analysis 472 Break-Even Analysis 473 Accounting Break-Even Analysis 474 450 Interpreting the Weighted-Average Cost of Capital 451 425 432 447 The Expected Return on Bonds 448 The Expected Return on Common Stock 448 The Expected Return on Preferred Stock 449 422 Company versus Project Risk 422 Determinants of Project Risk 423 Don’t Add Fudge Factors to Discount Rates Related Web Links 426 Key Terms 426 Quiz 426 Practice Problems 427 Challenge Problem 432 Solutions to Self-Test Questions 446 Calculating Required Rates of Return 414 Capital Budgeting and Project Risk Calculating Company Cost of Capital as a Weighted Average 440 Market versus Book Weights 441 Taxes and the Weighted-Average Cost of Capital 442 What If There Are Three (or More) Sources of Financing? 443 Wrapping Up Geothermal 444 Checking Our Logic 445 Measuring Capital Structure 411 Why the CAPM Works 416 The Security Market Line 417 How Well Does the CAPM Work? 419 Using the CAPM to Estimate Expected Returns Summary 407 VII 466 NPV Break-Even Analysis 475 Operating Leverage 478 Flexibility in Capital Budgeting Decision Trees 481 The Option to Expand 482 Abandonment Options 483 Flexible Production Facilities 484 Investment Timing Options 484 Summary 485 Related Web Links Key Terms 485 485 481 454 VIII CONTENTS Quiz 512 Practice Problems 513 Solutions to Self-Test Questions Quiz 485 Practice Problems 486 Challenge Problems 489 Solutions to Self-Test Questions Minicase 491 489 How Corporations Issue Securities Venture Capital An Overview of Corporate Financing 493 Common Stock Arranging a Public Issue The Underwriters Book Value versus Market Value 496 Dividends 497 Stockholders’ Rights 497 Voting Procedures 497 Classes of Stock 498 Corporate Governance in the United States and Elsewhere 498 499 Corporate Debt 500 General Cash Offers and Shelf Registration Costs of the General Cash Offer 529 Market Reaction to Stock Issues 530 507 Patterns of Corporate Financing 508 Do Firms Rely Too Heavily on Internal Funds? External Sources of Capital 510 526 General Cash Offers by Public Companies Debt Comes in Many Forms 501 Innovation in the Debt Market 504 Summary 526 The Private Placement Convertible Securities 508 Related Web Links Key Terms 512 532 Related Web Links 533 Key Terms 533 Quiz 534 Practice Problems 534 Challenge Problem 536 Solutions to Self-Test Questions Minicase 537 537 512 545 APPENDIX B Leasing 547 Lease or Buy? Leasing versus Buying A Preliminary Analysis 555 555 548 555 Operating Leases 548 Three Potential Pitfalls Financial Leases 549 NPV Analysis Tax-Oriented Leases Leveraged Leases 550 Sale and Leaseback Agreements Accounting and Leasing 552 The Cash Flows from Leasing The Incremental Cash Flows 554 550 556 Leverage and Capital Structure 559 The Capital Structure Question 560 550 Taxes, the IRS, and Leases 556 A Misconception 549 553 553 528 528 531 Appendix: Hotch Pot’s New Issue Prospectus 511 A Note on Taxes 520 521 Who Are the Underwriters? Summary 517 519 The Initial Public Offering 494 Preferred Stock 514 The Effect of Financial Leverage 560 The Impact of Financial Leverage 560 Financial Leverage, EPS, and ROE: An Example 561 EPS versus EBIT 561 539 CONTENTS 565 SECTION 6 Mergers, Acquisitions, and Corporate Control 567 22.1 The Market for Corporate Control 569 Method 1: Proxy Contests 569 Method 2: Mergers and Acquisitions 570 Method 3: Leveraged Buyouts 571 Method 4: Divestitures and Spin-offs 571 22.2 Sensible Motives for Mergers 572 Economies of Scale 573 Economies of Vertical Integration 573 Combining Complementary Resources 574 Mergers as a Use for Surplus Funds 574 22.3 Dubious Reasons for Mergers 575 Diversification 575 The Bootstrap Game 575 22.4 Evaluating Mergers 577 22.6 Leveraged Buyouts 587 588 Merger Waves 588 Do Mergers Generate Net Benefits? 22.8 Summary Glossary 589 590 APPENDIX C 635 23.2 Some Basic Relationships 598 602 Exchange Rates and Inflation 602 Inflation and Interest Rates 606 Interest Rates and Exchange Rates 608 The Forward Rate and the Expected Spot Rate Some Implications 610 23.5 Summary 585 22.7 Mergers and the Economy 23.1 Foreign Exchange Markets 625 617 Related Web Links 618 Key Terms 618 Quiz 618 Practice Problems 619 Challenge Problem 621 Solutions to Self-Test Questions Minicase 623 609 612 613 Net Present Value Analysis 613 The Cost of Capital for Foreign Investment Avoiding Fudge Factors 616 584 Barbarians at the Gate? International Financial Management 597 23.4 International Capital Budgeting 582 Who Gets the Gains? 595 23.3 Hedging Exchange Rate Risk Mergers Financed by Cash 577 Mergers Financed by Stock 579 A Warning 580 Another Warning 580 22.5 Merger Tactics Related Web Links 592 Key Terms 592 Quiz 592 Practice Problems 593 Challenge Problems 594 Solutions to Self-Test Questions Minicase 595 621 615 IX Section 1 The Firm and the Financial Manager The Time Value of Money Financial Statement Analysis THE FIRM AND THE FINANCIAL MANAGER Sole Proprietorships Who Is the Financial Manager? Partnerships Careers in Finance Corporations Goals of the Corporation Hybrid Forms of Business Organization Shareholders Want Managers to Maximize Market Value Organizing a Business The Role of the Financial Manager The Capital Budgeting Decision The Financing Decision Financial Institutions and Markets Ethics and Management Objectives Do Managers Really Maximize Firm Value? Snippets of History Summary Financial Institutions Financial Markets Other Functions of Financial Markets and Institutions A meeting of a corporation’s directors. Most large businesses are organized as corporations. Corporations are owned by stockholders, who vote in a board of directors. The directors appoint the corporation’s top executives and approve major financial decisions. Comstock, Inc. 3 T his material is an introduction to corporate finance. We will discuss the various responsibilities of the corporation’s financial managers and show you how to tackle many of the problems that these managers are expected to solve. We begin with a discussion of the corporation, the finan- cial decisions it needs to make, and why they are important. To survive and prosper, a company must satisfy its customers. It must also produce and sell products and services at a profit. In order to produce, it needs many assets— plant, equipment, offices, computers, technology, and so on. The company has to decide (1) which assets to buy and (2) how to pay for them. The financial manager plays a key role in both these decisions. The investment decision, that is, the decision to invest in assets like plant, equipment, and know-how, is in large part a responsibility of the financial manager. So is the financing decision, the choice of how to pay for such investments. We start by explaining how businesses are organized. We then provide a brief introduction to the role of the financial manager and show you why corporate managers need a sophisticated understanding of financial markets. Next we turn to the goals of the firm and ask what makes for a good financial decision. Is the firm’s aim to maximize profits? To avoid bankruptcy? To be a good citizen? We consider some conflicts of interest that arise in large organizations and review some mechanisms that align the interests of the firm’s managers with the interests of its owners. Finally, we provide an overview of what is to come. After studying this material you should be able to 䉴 Explain the advantages and disadvantages of the most common forms of business organization and determine which forms are most suitable to different types of businesses. 䉴 Cite the major business functions and decisions that the firm’s financial managers are responsible for and understand some of the possible career choices in finance. 䉴 Explain the role of financial markets and institutions. 䉴 Explain why it makes sense for corporations to maximize their market values. 䉴 Show why conflicts of interest may arise in large organizations and discuss how corporations can provide incentives for everyone to work toward a common end. Organizing a Business SOLE PROPRIETORSHIPS In 1901 pharmacist Charles Walgreen bought the drugstore in which he worked on the South Side of Chicago. Today Walgreen’s is the largest drugstore chain in the United States. If, like Charles Walgreen, you start on your own, with no partners or stockholders, you are said to be a sole proprietor. You bear all the costs and keep all the profits 4 The Firm and the Financial Manager SOLE PROPRIETOR Sole owner of a business which has no partners and no shareholders. The proprietor is personally liable for all the firm’s obligations. 5 after the Internal Revenue Service has taken its cut. The advantages of a proprietorship are the ease with which it can be established and the lack of regulations governing it. This makes it well-suited for a small company with an informal business structure. As a sole proprietor, you are responsible for all the business’s debts and other liabilities. If the business borrows from the bank and subsequently cannot repay the loan, the bank has a claim against your personal belongings. It could force you into personal bankruptcy if the business debts are big enough. Thus as sole proprietor you have unlimited liability. PARTNERSHIPS PARTNERSHIP Business owned by two or more persons who are personally responsible for all its liabilities. Instead of starting on your own, you may wish to pool money and expertise with friends or business associates. If so, a sole proprietorship is obviously inappropriate. Instead, you can form a partnership. Your partnership agreement will set out how management decisions are to be made and the proportion of the profits to which each partner is entitled. The partners then pay personal income tax on their share of these profits. Partners, like sole proprietors, have the disadvantage of unlimited liability. If the business runs into financial difficulties, each partner has unlimited liability for all the business’s debts, not just his or her share. The moral is clear and simple: “Know thy partner.” Many professional businesses are organized as partnerships. They include the large accounting, legal, and management consulting firms. Most large investment banks such as Morgan Stanley, Salomon, Smith Barney, Merrill Lynch, and Goldman Sachs started life as partnerships. So did many well-known companies, such as Microsoft and Apple Computer. But eventually these companies and their financing requirements grew too large for them to continue as partnerships. CORPORATIONS CORPORATION Business owned by stockholders who are not personally liable for the business’s liabilities. LIMITED LIABILITY The owners of the corporation are not personally responsible for its obligations. As your firm grows, you may decide to incorporate. Unlike a proprietorship or partnership, a corporation is legally distinct from its owners. It is based on articles of incorporation that set out the purpose of the business, how many shares can be issued, the number of directors to be appointed, and so on. These articles must conform to the laws of the state in which the business is incorporated. For many legal purposes, the corporation is considered a resident of its state. For example, it can borrow or lend money, and it can sue or be sued. It pays its own taxes (but it cannot vote!). The corporation is owned by its stockholders and they get to vote on important matters. Unlike proprietorships or partnerships, corporations have limited liability, which means that the stockholders cannot be held personally responsible for the obligations of the firm. If, say, IBM were to fail, no one could demand that its shareholders put up more money to pay off the debts. The most a stockholder can lose is the amount invested in the stock. While the stockholders of a corporation own the firm, they do not usually manage it. Instead, they elect a board of directors, which in turn appoints the top managers. The board is the representative of shareholders and is supposed to ensure that management is acting in their best interests. This separation of ownership and management is one distinctive feature of corporations. In other forms of business organization, such as proprietorships and partnerships, the owners are the managers. The separation between management and ownership gives a corporation more flexibility and permanence than a partnership. Even if managers of a corporation quit or are 6 SECTION ONE dismissed and replaced by others, the corporation can survive. Similarly, today’s shareholders may sell all their shares to new investors without affecting the business. In contrast, ownership of a proprietorship cannot be transferred without selling out to another owner-manager. By organizing as a corporation, a business may be able to attract a wide variety of investors. The shareholders may include individuals who hold only a single share worth a few dollars, receive only a single vote, and are entitled to only a tiny proportion of the profits. Shareholders may also include giant pension funds and insurance companies whose investment in the firm may run into the millions of shares and who are entitled to a correspondingly large number of votes and proportion of the profits. Given these advantages, you might be wondering why all businesses are not organized as corporations. One reason is the time and cost required to manage a corporation’s legal machinery. There is also an important tax drawback to corporations in the United States. Because the corporation is a separate legal entity, it is taxed separately. So corporations pay tax on their profits, and, in addition, shareholders pay tax on any dividends that they receive from the company.1 By contrast, income received by partners and sole proprietors is taxed only once as personal income. When you first establish a corporation, the shares may all be held by a small group, perhaps the company’s managers and a small number of backers who believe the business will grow into a profitable investment. Your shares are not publicly traded and your company is closely held. Eventually, when the firm grows and new shares are issued to raise additional capital, the shares will be widely traded. Such corporations are known as public companies. Most well-known corporations are public companies.2 To summarize, the corporation is a distinct, permanent legal entity. Its advantages are limited liability and the ease with which ownership and management can be separated. These advantages are especially important for large firms. The disadvantage of corporate organization is double taxation. The financial managers of a corporation are responsible, by way of top management and the board of directors, to the corporation’s shareholders. Financial managers are supposed to make financial decisions that serve shareholders’ interests. Table 1.1 presents the distinctive features of the major forms of business organization. HYBRID FORMS OF BUSINESS ORGANIZATION Businesses do not always fit into these neat categories. Some are hybrids of the three basic types: proprietorships, partnerships, and corporations. For example, businesses can be set up as limited partnerships. In this case, partners are classified as general or limited. General partners manage the business and have unlimited personal liability for the business’s debts. Limited partners, however, are liable only for the money they contribute to the business. They can lose everything they put in, but not more. Limited partners usually have a restricted role in management. In many states a firm can also be set up as a limited liability partnership (LLP) or, equivalently, a limited liability company (LLC). These are partnerships in which all The United States is unusual in its taxation of corporations. To avoid taxing the same income twice, most other countries give shareholders at least some credit for the taxes that their company has already paid. 2 For example, when Microsoft was initially established as a corporation, its shares were closely held by a small number of employees and backers. Microsoft shares were issued to the public in 1986. 1 The Firm and the Financial Manager TABLE 1.1 Characteristics of business organizations Sole Proprietorship Partnership Corporation Who owns the business? The manager Partners Shareholders Are managers and owner(s) separate? No No Usually What is the owner’s liability? Unlimited Unlimited Limited Are the owner and business taxed separately? No No Yes 7 partners have limited liability. This form of business organization combines the tax advantage of partnership with the limited liability advantage of incorporation. However, it still does not suit the largest firms, for which widespread share ownership and separation of ownership and management are essential. Another variation on the theme is the professional corporation (PC), which is commonly used by doctors, lawyers, and accountants. In this case, the business has limited liability, but the professionals can still be sued personally for malpractice, even if the malpractice occurs in their role as employees of the corporation. 䉴 Self-Test 1 Which form of business organization might best suit the following? a. A consulting firm with several senior consultants and support staff. b. A house painting company owned and operated by a college student who hires some friends for occasional help. c. A paper goods company with sales of $100 million and 2,000 employees. The Role of the Financial Manager Assets used to produce goods and services. REAL ASSETS FINANCIAL ASSETS Claims to the income generated by real assets. Also called securities. To carry on business, companies need an almost endless variety of real assets. Many of these assets are tangible, such as machinery, factories, and offices; others are intangible, such as technical expertise, trademarks, and patents. All of them must be paid for. To obtain the necessary money, the company sells financial assets, or securities.3 These pieces of paper have value because they are claims on the firm’s real assets and the cash that those assets will produce. For example, if the company borrows money from the bank, the bank has a financial asset. That financial asset gives it a claim to a 3 For present purposes we are using financial assets and securities interchangeably, though “securities” usually refers to financial assets that are widely held, like the shares of IBM. An IOU (“I owe you”) from your brother-in-law, which you might have trouble selling outside the family, is also a financial asset, but most people would not think of it as a security. 8 SECTION ONE FIGURE 1.1 Flow of cash between capital markets and the firm’s operations. Key: (1) Cash raised by selling financial assets to investors; (2) cash invested in the firm’s operations; (3) cash generated by the firm’s operations; (4a) cash reinvested; (4b) cash returned to investors. FINANCIAL MARKETS Markets in which financial assets are traded. CAPITAL BUDGETING DECISION Decision as to which real assets the firm should acquire. FINANCING DECISION Decision as to how to raise the money to pay for investments in real assets. Firm’s operations (a bundle of real assets) (2) (1) Financial manager (3) (4a) (4b) Financial markets (investors holding financial assets) stream of interest payments and to repayment of the loan. The company’s real assets need to produce enough cash to satisfy these claims. Financial managers stand between the firm’s real assets and the financial markets in which the firm raises cash. The financial manager’s role is shown in Figure 1.1, which traces how money flows from investors to the firm and back to investors again. The flow starts when financial assets are sold to raise cash (arrow 1 in the figure). The cash is employed to purchase the real assets used in the firm’s operations (arrow 2). Later, if the firm does well, the real assets generate enough cash inflow to more than repay the initial investment (arrow 3). Finally, the cash is either reinvested (arrow 4a) or returned to the investors who contributed the money in the first place (arrow 4b). Of course the choice between arrows 4a and 4b is not a completely free one. For example, if a bank lends the firm money at stage 1, the bank has to be repaid this money plus interest at stage 4b. This flow chart suggests that the financial manager faces two basic problems. First, how much money should the firm invest, and what specific assets should the firm invest in? This is the firm’s investment, or capital budgeting, decision. Second, how should the cash required for an investment be raised? This is the financing decision. THE CAPITAL BUDGETING DECISION Capital budgeting decisions are central to the company’s success or failure. For example, in the late 1980s, the Walt Disney Company committed to construction of a Disneyland Paris theme park at a total cost of well over $2 billion. The park, which opened in 1992, turned out to be a financial bust, and Euro Disney had to reorganize in May 1994. Instead of providing profits on the investment, accumulated losses on the park by that date were more than $200 million. Contrast that with Boeing’s decision to “bet the company” by developing the 757 and 767 jets. Boeing’s investment in these planes was $3 billion, more than double the total value of stockholders’ investment as shown in the company’s accounts at the time. By 1997, estimated cumulative profits from this investment were approaching $8 billion, and the planes were still selling well. Disney’s decision to invest in Euro Disney and Boeing’s decision to invest in a new generation of airliners are both examples of capital budgeting decisions. The success of such decisions is usually judged in terms of value. Good investment projects are worth more than they cost. Adopting such projects increases the value of the firm and therefore the wealth of its shareholders. For example, Boeing’s investment produced a stream of cash flows that were worth much more than its $3 billion outlay. Not all investments are in physical plant and equipment. For example, Gillette spent around $300 million to market its new Mach3 razor. This represents an investment in a The Firm and the Financial Manager 9 nontangible asset—brand recognition and acceptance. Moreover, traditional manufacturing firms are not the only ones that make important capital budgeting decisions. For example, Intel’s research and development expenditures in 1998 were more than $2.5 billion.4 This investment in future products and product improvement will be crucial to the company’s ability to retain its existing customers and attract new ones. Today’s investments provide benefits in the future. Thus the financial manager is concerned not solely with the size of the benefits but also with how long the firm must wait for them. The sooner the profits come in, the better. In addition, these benefits are rarely certain; a new project may be a great success—but then again it could be a dismal failure. The financial manager needs a way to place a value on these uncertain future benefits. We will spend considerable time in later material on project evaluation. While no one can guarantee that you will avoid disasters like Euro Disney or that you will be blessed with successes like the 757 and 767, a disciplined, analytical approach to project proposals will weight the odds in your favor. THE FINANCING DECISION CAPITAL STRUCTURE Firm’s mix of long-term financing. CAPITAL MARKETS Markets for long-term financing. The financial manager’s second responsibility is to raise the money to pay for the investment in real assets. This is the financing decision. When a company needs financing, it can invite investors to put up cash in return for a share of profits or it can promise investors a series of fixed payments. In the first case, the investor receives newly issued shares of stock and becomes a shareholder, a part-owner of the firm. In the second, the investor becomes a lender who must one day be repaid. The choice of the longterm financing mix is often called the capital structure decision, since capital refers to the firm’s sources of long-term financing, and the markets for long-term financing are called capital markets.5 Within the basic distinction—issuing new shares of stock versus borrowing money —there are endless variations. Suppose the company decides to borrow. Should it go to capital markets for long-term debt financing or should it borrow from a bank? Should it borrow in Paris, receiving and promising to repay euros, or should it borrow dollars in New York? Should it demand the right to pay off the debt early if future interest rates fall? The decision to invest in a new factory or to issue new shares of stock has long-term consequences. But the financial manager is also involved in some important short-term decisions. For example, she needs to make sure that the company has enough cash on hand to pay next week’s bills and that any spare cash is put to work to earn interest. Such short-term financial decisions involve both investment (how to invest spare cash) and financing (how to raise cash to meet a short-term need). Businesses are inherently risky, but the financial manager needs to ensure that risks are managed. For example, the manager will want to be certain that the firm cannot be wiped out by a sudden rise in oil prices or a fall in the value of the dollar. We will look at the techniques that managers use to explore the future and some of the ways that the firm can be protected against nasty surprises. 4 Accountants may treat investments in R&D differently than investments in plant and equipment. But it is clear that both investments are creating real assets, whether those assets are physical capital or know-how; both investments are essential capital budgeting activities. 5 Money markets are used for short-term financing.
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