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Table of Contents Part I Introduction to Financial Management Chapter 1 An Overview of Financial Management 2 Striking the Right Balance Putting Things in Perspective Career Opportunities in Finance Financial Management in the New Millennium Global Perspectives Coke Rides the Global Economy Wave Technology Matters eToys Takes on Toys R Us The Financial Staff’s Responsibilities Alternative Forms of Business Organization Finance in the Organizational Structure of the Firm The Goals of the Corporation Industry Practice Levi Strauss Tries to Blend Profits with Social Activism Business Ethics Agency Relationships Industry Practice Are CEOs Overpaid? Managerial Actions to Maximize Shareholder Wealth Does it Make Sense to Try to Maximize Earnings Per Share? Organization of the Book Tying It All Together Chapter 2 Financial Statements, Cash Flow, and Taxes 34 Doing Your Homework with Financial Statements Putting Things in Perspective A Brief History of Accounting and Financial Statements Financial Statements and Reports The Balance Sheet The Income Statement Statement of Retained Earnings Technology Matters Financial Analysis on the Internet Industry Practice Analysts Are Increasingly Relying on Cash Flow to Value Stocks Net Cash Flow Industry Practice In Valuing Stocks, Is It Earnings or Cash Flow That Matters? Statement of Cash Flows Modifying Accounting Data for Managerial Decisions MVA and EVA Industry Practice Many Firms Adopt EVA in an Attempt to Enhance Shareholder Wealth The Federal Income Tax System Global Perspectives Tax Havens Depreciation Tying It All Together Chapter 3 Analysis of Financial Statements 86 The Gap Warns Wall Street Putting Things in Perspective Ratio Analysis Liquidity Ratios Asset Management Ratios Debt Management Ratios Profitability Ratios Global Perspectives International Accounting Differences Create Headaches for Investors Market Value Ratios Technology Matters eBay’s Financial Statements Trend Analysis Tying the Ratios Together: The Du Pont Chart and Equation Comparative Ratios and "Benchmarking" Uses and Limitations of Ratio Analysis Problems with ROE Industry Practice Calculating EVA Looking Beyond the Numbers Small Business Financial Analysis in the Small Firm Tying It All Together Chapter 4 Financial Planning and Forecasting 132 Forecasting Disney’s Future Putting Things in Perspective Strategic Plans Operating Plans The Financial Plan Computerized Financial Planning Models Sales Forecasts Financial Statement Forecasting: The Percent of Sales Method The AFN Formula Forecasting Financial Requirements When the Balance Sheet Ratios Are Subject to Change Other Techniques for Forecasting Financial Statements Tying It All Together Chapter 5 The Financial Environment: Markets, Institutions, and Interest Rates 176 Charles Schwab and Merrill Lynch Compete in a Changing Environment Putting Things in Perspective The Financial Markets Financial Institutions The Stock Market Technology Matters Online Trading Systems Industry Practice A Very Expensive Beer The Cost of Money Industry Practice Measuring the Market Interest Rate Levels The Determinants of Market Interest Rates Industry Practice A New, Almost Riskless Treasury Bond The Term Structure of Interest Rates What Determines the Shape of the Yield Curve? Using the Yield Curve to Estimate Future Interest Rates Investing Overseas Global Perspectives Measuring Country Risk Other Factors That Influence Interest Rate Levels Interest Rates and Business Decisions Tying It All Together Part II Fundamental Concepts in Financial Management Chapter 6 Risk and Rates of Return 230 No Pain No Gain Putting Things in Perspective Investment Returns Stand-Alone Risk Industry Practice The Trade-Off between Risk and Return Risk in a Portfolio Context Global Perspectives The Benefits of Diversifying Overseas Industry Practice Is the Dow Jones Heading to 36,000? The Relationship Between Risk and Rates of Return Industry Practice Estimating the Market Risk Premium Physical Assets versus Securities Some Concerns about Beta and the CAPM Volatility versus Risk Tying It All Together Appendix 6A Calculating Beta Coefficients Chapter 7 Time Value of Money 288 Will You Be Able to Retire? Putting Things in Perspective Time Lines Future Value Industry Practice The Power of Compound Interest Present Value Solving for Interest Rate and Time Future Value of an Annuity Present Value of an Annuity Perpetuities Uneven Cash Flow Streams Semiannual and Other Compounding Periods Technology Matters Using the Internet for Personal Financial Planning Comparison of Different Types of Interest Rates Fractional Time Periods Amortized Loans Tying It All Together Appendix 7A Continuous Compounding and Discounting Part III Financial Assets Chapter 8 Bonds and Their Valuation 348 Ford’s Bond Issue Sets a New Record Putting Things in Perspective Who Issues Bonds? Key Characteristics of Bonds Bond Valuation Bond Yields Global Perspectives Drinking Your Coupons Bonds with Semiannual Coupons Assessing the Riskiness of a Bond Technology Matters S&P Develops Criteria to Determine Bond Ratings for Internet Firms Industry Practice Santa Fe Bonds Finally Mature after 114 Years Bond Markets Tying It All Together Appendix 8A Zero Coupon Bonds Appendix 8B Bankruptcy and Reorganization Chapter 9 Stocks and Their Valuation 406 AOL Takes Investors on an Exciting Roller Coaster Ride Putting Things in Perspective Legal Rights and Privileges of Common Stockholders Types of Common Stock The Market for Common Stock Industry Practice Martha Bodyslams WWF Common Stock Valuation Constant Growth Stocks Expected Rate of Return on a Constant Growth Stock Industry Practice Other Approaches to Valuing Common Stocks Valuing Stocks That Have a Nonconstant Growth Rate Valuing the Entire Corporation Industry Practice Evaluating Stocks That Don’t Pay Dividends Stock Market Equilibrium Technology Matters A Nation of Traders Actual Stock Prices and Returns Global Perspectives Investing in Emerging Markets Preferred Stock Tying It All Together Part IV Investing in Long-Term Assets: Capital Budgeting Chapter 10 The Cost of Capital 460 Creating Value at GE Putting Things in Perspective The Logic of the Weighted Average Cost of Capital Basic Definitions Cost of Debt, kd(1 - T) Cost of Preferred Stock, kp Industry Practice Funny-Named Preferred-Like Securities Cost of Retained Earnings, ks Cost of New Common Stock, ke Technology Matters Trends in Technology: Estimating the Cost of Capital for Internet Companies Industry Practice How Much Does It Cost to Raise External Capital? Composite, or Weighted Average, Cost of Capital, WACC Industry Practice WACC Estimates for Some Large U.S. Corporations Factors that Affect the Composite Cost of Capital Global Perspectives Global Variations in the Cost of Capital Adjusting the Cost of Capital for Risk Estimating Project Risk Using the CAPM to Estimate the Risk-Adjusted Cost of Capital Techniques for Measuring Beta Risk Some Problem Areas in Cost of Capital Small Business The Cost of Equity Capital for Small Firms Tying It All Together Chapter 11 The Basics of Capital Budgeting 504 Boeing Recovers from Its Financial Tailspin Putting Things in Perspective Importance of Capital Budgeting Generating Ideas for Capital Projects Project Classifications Similarities between Capital Budgeting and Security Valuation Capital Budgeting Decision Rules Modified Internal Rate of Return (MIRR) Conclusions on Capital Budgeting Methods Business Practices Industry Practice Techniques Firms Use to Evaluate Corporate Projects The Post-Audit Small Business Capital Budgeting in the Small Firm Using Capital Budgeting Techniques in Other Contexts Tying It All Together Chapter 12 Cash Flow Estimation and Risk Analysis 546 Home Depot Keeps Growing Putting Things in Perspective Estimating Cash Flows Identifying the Relevant Cash Flows Evaluating Capital Budgeting Projects Introduction to Project Risk Analysis Techniques for Measuring Stand-Alone Risk Global Perspectives Capital Budgeting Practices in the Asia/Pacific Region Technology Matters High-Tech CFOs Project Risk Conclusions Incorporating Project Risk and Capital Structure into Capital Budgeting Incorporating Real Options into the Capital Budgeting Decision The Optimal Capital Budget Tying It All Together Appendix 12A Depreciation Part V Capital Structure and Dividend Policy Chapter 13 Capital Structure and Leverage 594 Debt: Rocket Booster or Anchor? Putting Things in Perspective The Target Capital Structure Business and Financial Risk Determining the Optimal Capital Structure Industry Practice Yogi Berra on the M&M Proposition Capital Structure Theory Checklist for Capital Structure Decisions Variations in Capital Structures Global Perspectives Taking a Look at Global Capital Structures Tying It All Together Chapter 14 Distributions to Shareholders: Dividends and Share Repurchases 640 FPL Stuns the Market by Changing Its Dividend Policy Putting Things in Perspective Dividends versus Capital Gains: What Do Investors Prefer? Global Perspectives Dividend Yields around the World Other Dividend Policy Issues Dividend Stability Establishing the Dividend Policy in Practice Dividend Reinvestment Plans Summary of Factors Influencing Dividend Policy Overview of the Dividend Policy Decision Stock Dividends and Stock Splits Technology Matters Looking Online for Information on Dividends, Stock Splits, and Stock Repurchases Stock Repurchases Industry Practice Buybacks Have Lowered Dividend Yields Industry Practice Stock Repurchases: An Easy Way to Boost Stock Prices? Tying It All Together Part VI Working Capital Management and Multinational Financial Management Chapter 15 Working Capital Management 686 Dell Revolutionizes Working Capital Management Putting Things in Perspective Working Capital Terminology The Cash Conversion Cycle Alternative Current Asset Investment Policies Industry Practice Free Cash Flow, EVA, and Working Capital Cash Management The Cash Budget Industry Practice The Great Debate: How Much Cash is Enough? Marketable Securities Inventory Inventory Costs Industry Practice Supply Chain Management Receivables Management Credit Policy Financing Current Assets Alternative Current Asset Financing Policies Advantages and Disadvantages for Short-Term Financing Sources of Short-Term Financing Accruals Accounts Payable (Trade Credit) Technology Matters The Internet Threatens to Transform the Banking Industry Short-Term Bank Loans Commercial Paper Use of Security in Short-Term Financing Tying It All Together Chapter 16 Multinational Financial Management 744 U.S. Firms Look Overseas to Enhance Shareholder Value Putting Things in Perspective Multinational, or Global, Corporations Multinational versus Domestic Financial Management Global Perspectives The Euro: What You Need to Know Exchange Rates The International Monetary System Trading in Foreign Exchange Interest Rate Parity Purchasing Power Parity Global Perspectives Hungry for a Big Mac? Go to Malaysia! Inflation, Interest Rates, and Exchange Rates International Money and Capital Markets Industry Practice Stock Market Indices around the World Multinational Capital Budgeting International Capital Structures Multinational Working Capital Management Tying It All Together An Overview of Financial 1 CHAPTER Management SOURCE: Courtesy BEN & JERRY’S HOMEMADE, INC. www.benjerry.com STRIKING THE RIGHT BALANCE $ BEN & JERRY'S or many companies, the decision would have beenake money. For example, in a recent article in Fortune F an easy “yes.” However, Ben & Jerry’s Homemademagazine, Alex Taylor III commented that, “Operating a Inc. has always taken pride in doing things business is tough enough. Once you add social goals to differently. Its proﬁts had been declining, but in 1995demands of serving customers, making a proﬁt, and the company was offered an opportunity to sell its returning value to shareholders, you tie yourself up in premium ice cream in the lucrative Japanese market.knots.” However, Ben & Jerry’s turned down the business Ben & Jerry’s ﬁnancial performance has had its ups because the Japanese ﬁrm that would have distributednd downs. While the company’s stock grew by leaps their product had failed to develop a reputation fornd bounds through the early 1990s, problems began to promoting social causes! Robert Holland Jr., Ben & arise in 1993. These problems included increased Jerry’s CEO at the time, commented that, “The only competition in the premium ice cream market, along reason to take the opportunity was to make money.” with a leveling off of sales in that market, plus their Clearly, Holland, who resigned from the company in lateinefﬁciencies and sloppy, haphazard product 1996, thought there was more to running a business development strategy. than just making money. The company lost money for the ﬁrst time in 1994, The company’s cofounders, Ben Cohen and Jerry and as a result, Ben Cohen stepped down as CEO. Bob Greenﬁeld, opened the ﬁrst Ben & Jerry’s ice cream shopand, a former consultant for McKinsey & Co. with a in 1978 in a vacant Vermont gas station with just reputation as a turnaround specialist, was tapped as $12,000 of capital plus a commitment to run the business’s replacement. The company’s stock price rebounded in 1995, as the market responded positively in a manner consistent with their underlying values. Even though it is more expensive, the company only buys milkhe steps made by Holland to right the company. The and cream from small local farms in Vermont. In addition,price, however, ﬂoundered toward the end of 7.5 percent of the company’s before-tax income is 1996, following Holland’s resignation. donated to charity, and each of the company’s 750 Over the last few years, Ben & Jerry’s has had a new employees receives three free pints of ice cream each day.nce. Holland’s replacement, Perry Odak, has done Many argue that Ben & Jerry’s philosophy and a number of things to improve the company’s ﬁnancial commitment to social causes compromises its ability toformance, and its reputation among Wall Street’s 3 analysts and institutional investors has beneﬁted. Odak response to these concerns, Ben & Jerry’s will retain its quickly brought in a new management team to rework Vermont headquarters and its separate board, and its the company’s production and sales operations, and he social missions will remain intact. Others have aggressively opened new stores and franchises both in suggested that Ben & Jerry’s philosophy may even the United States and abroad. induce Unilever to increase its own corporate In April 2000, Ben & Jerry’s took a more dramatic philanthropy. Despite these assurances, it still remains step to beneﬁt its shareholders. It agreed to be acquired to be seen whether Ben & Jerry’s vision can be by Unilever, a large Anglo-Dutch conglomerate that maintained within the conﬁnes of a large conglomerate. owns a host of major brands including Dove Soap, As you will see throughout the book, many of today’s Lipton Tea, and Breyers Ice Cream. Unilever agreed to companies face challenges similar to those of Ben & pay $43.60 for each share of Ben & Jerry’s stock—a 66 Jerry’s. Every day, corporations struggle with decisions percent increase over the price the stock traded at just such as these: Is it fair to our labor force to shift before takeover rumors ﬁrst surfaced in December 1999. production overseas? What is the appropriate level of The total price tag for Ben & Jerry’s was $326 million. compensation for senior management? Should we While the deal clearly beneﬁted Ben & Jerry’s increase, or decrease, our charitable contributions? In shareholders, some observers believe that the company general, how do we balance social concerns against the “sold out” and abandoned its original mission. In need to create shareholder value? I See http:// The purpose of this chapter is to give you an idea of what ﬁnancial management www.benjerry.com/ mission.html for Ben & is all about. After you ﬁnish the chapter, you should have a reasonably good idea Jerry’s interesting mission statement. It might be a of what ﬁnance majors might do after graduation. You should also have a better good idea to print it out and take it to class for discussion. understanding of (1) some of the forces that will affect ﬁnancial management in the future; (2) the place of ﬁnance in a ﬁrm’s organization; (3) the relationships between ﬁnancial managers and their counterparts in the accounting, marketing, production, and personnel departments; (4) the goals of a ﬁrm; and (5) the way ﬁnancial managers can contribute to the attainment of these goals. I Information on ﬁnance CAREER OPPORTUNITIES IN FINANCE careers, additional chapter links, and practice quizzes are available on the web site to accompany this Finance consists of three interrelated areas: (1) money and capital markets, which text: http://www.harcourtcollege. deals with securities markets and ﬁnancial institutions; (2) investments, which fo- com/ﬁnance/concise3e. cuses on the decisions made by both individual and institutional investors as 4 CHAPTER 1 I AN OVERVIEW OF FINANCIAL MANAGEMENT they choose securities for their investment portfolios; and (3) ﬁnancial manage- ment, or “business ﬁnance,” which involves decisions within ﬁrms. The career opportunities within each ﬁeld are many and varied, but ﬁnancial managers must have a knowledge of all three areas if they are to do their jobs well. M ONEY AND CAPITAL M ARKETS Many ﬁnance majors go to work for ﬁnancial institutions, including banks, in- surance companies, mutual funds, and investment banking ﬁrms. For success here, one needs a knowledge of valuation techniques, the factors that cause in- terest rates to rise and fall, the regulations to which ﬁnancial institutions are subject, and the various types of ﬁnancial instruments (mortgages, auto loans, certiﬁcates of deposit, and so on). One also needs a general knowledge of all as- pects of business administration, because the management of a ﬁnancial insti- tution involves accounting, marketing, personnel, and computer systems, as well as ﬁnancial management. An ability to communicate, both orally and in writing, is important, and “people skills,” or the ability to get others to do their jobs well, are critical. INVESTMENTS Consult http:// Finance graduates who go into investments often work for a brokerage house www.careers-in- such as Merrill Lynch, either in sales or as a security analyst. Others work for business.com for an banks, mutual funds, or insurance companies in the management of their in- excellent site containvestment portfolios; for ﬁnancial consulting ﬁrms advising individual investors information on a variety of business career areas, listings of current funds on how to invest their capital; for investment banks whose pri- jobs, and a variety of other refmary function is to help businesses raise new capital; or as ﬁnancial planners materials. whose job is to help individuals develop long-term ﬁnancial goals and portfolios. The three main functions in the investments area are sales, analyzing individual securities, and determining the optimal mix of securities for a given investor. F INANCIAL M ANAGEMENT Financial management is the broadest of the three areas, and the one with the most job opportunities. Financial management is important in all types of busi- nesses, including banks and other ﬁnancial institutions, as well as industrial and retail ﬁrms. Financial management is also important in governmental opera- tions, from schools to hospitals to highway departments. The job opportunities in ﬁnancial management range from making decisions regarding plant expan- sions to choosing what types of securities to issue when ﬁnancing expansion. Financial managers also have the responsibility for deciding the credit terms under which customers may buy, how much inventory the ﬁrm should carry, how much cash to keep on hand, whether to acquire other ﬁrms (merger analy- sis), and how much of the ﬁrm’s earnings to plow back into the business versus pay out as dividends. Regardless of which area a ﬁnance major enters, he or she will need a knowl- edge of all three areas. For example, a bank lending ofﬁcer cannot do his or her CAREER OPPORTUNITIES IN FINANCE 5 job well without a good understanding of ﬁnancial management, because he or she must be able to judge how well a business is being operated. The same thing holds true for Merrill Lynch’s security analysts and stockbrokers, who must have an understanding of general ﬁnancial principles if they are to give their cus- tomers intelligent advice. Similarly, corporate ﬁnancial managers need to know what their bankers are thinking about, and they also need to know how investors judge a ﬁrm’s performance and thus determine its stock price. So, if you decide to make ﬁnance your career, you will need to know something about all three areas. But suppose you do not plan to major in ﬁnance. Is the subject still important to you? Absolutely, for two reasons: (1) You need a knowledge of ﬁnance to make many personal decisions, ranging from investing for your retirement to decid- ing whether to lease versus buy a car. (2) Virtually all important business deci- sions have ﬁnancial implications, so important decisions are generally made by teams from the accounting, ﬁnance, legal, marketing, personnel, and production departments. Therefore, if you want to succeed in the business arena, you must be highly competent in your own area, say, marketing, but you must also have a familiarity with the other business disciplines, including ﬁnance. Thus, there are ﬁnancial implications in virtually all business decisions, and nonﬁ- nancial executives simply mus1 know enough ﬁnance to work these implications into their own specialized analyses. Because of this, every student of business, regard- less of his or her major, should be concerned with ﬁnancial management. SELF-TEST QUESTIONS What are the three main areas of ﬁnance? If you have deﬁnite plans to go into one area, why is it necessary that you know something about the other areas? Why is it necessary for business students who do not plan to major in ﬁ- nance to understand the basics of ﬁnance? FINANCIAL MANAGEMENT IN THE NEW MILLENNIUM When ﬁnancial management emerged as a separate ﬁeld of study in the early 1900s, the emphasis was on the legal aspects of mergers, the formation of new ﬁrms, and the various types of securities ﬁrms could issue to raise capital. Dur- ing the Depression of the 1930s, the emphasis shifted to bankruptcy and reor- ganization, corporate liquidity, and the regulation of security markets. During the 1940s and early 1950s, ﬁnance continued to be taught as a descriptive, in- stitutional subject, viewed more from the standpoint of an outsider rather than that of a manager. However, a movement toward theoretical analysis began during the late 1950s, and the focus shifted to managerial decisions designed to maximize the value of the ﬁrm. 1 It is an interesting fact that the course “Financial Management for Nonﬁnancial Executives” has the highest enrollment in most executive development programs. 6 CHAPTER 1 I AN OVERVIEW OF FINANCIAL MANAGEMENT The focus on value maximization continues as we begin the 21st century. However, two other trends are becoming increasingly important: (1) the glob- alization of business and (2) the increased use of information technology. Both of these trends provide companies with exciting new opportunities to increase proﬁtability and reduce risks. However, these trends are also leading to in- creased competition and new risks. To emphasize these points throughout the book, we regularly proﬁle how companies or industries have been affected by increased globalization and changing technology. These proﬁles are found in the boxes labeled “Global Perspectives” and “Technology Matters.” G LOBALIZATION OF B USINESS Many companies today rely to a large and increasing extent on overseas opera- tions. Table 1-1 summarizes the percentage of overseas revenues and proﬁts for 10 well-known corporations. Very clearly, these 10 “American” companies are really international concerns. Check out http:// Four factors have led to the increased globalization of businesses: (1) Im- www.nummi.com/ provements in transportation and communications lowered shipping costs and made international trade more feasible. (2) The increasing political clout of home.htm to ﬁnd out more about New United consumers, who desire low-cost, high-quality products. This has helped lower Motor Manufacturing, Inctrade barriers designed to protect inefﬁcient, high-cost domestic manufacturers (NUMMI), the joint venture between and their workers. (3) As technology has become more advanced, the costs of Toyota and General Motors. Read about NUMMI’s history and organizational developing new products have increased. These rising costs have led to joint goals. ventures between such companies as General Motors and Toyota, and to global operations for many ﬁrms as they seek to expand markets and thus spread development costs over higher unit sales. (4) In a world populated with multi- national ﬁrms able to shift production to wherever costs are lowest, a ﬁrm whose manufacturing operations are restricted to one country cannot compete unless costs in its home country happen to be low, a condition that does not TABLE 1-1 Percentage of Revenue and Net Income from Overseas Operations for 10 Well-Known Corporations PERCENTAGE OF REVENUE PERCENTAGE OF NET INCOME COMPANY ORIGINATED OVERSEAS GENERATED OVERSEAS Chase Manhattan 23.9 21.9 Coca-Cola 61.2 65.1 Exxon Mobil 71.8 62.7 General Electric 31.7 22.8 General Motors 26.355.3 IBM 57.5 49.6 McDonald’s 61.6 60.9 Merck 21.6 43.4 Minn. Mining & Mfg. 52.1 27.2 Walt Disney 15.4 16.6 SOURCE: Forbes Magazine’s 1999 Ranking of the 100 Largest U.S. Multinationals; Forbes, July 24, 2000, 335–338. FINANCIAL MANAGEMENT IN THE NEW MILLENNIUM 7 COKE RIDES THE GLOB AL ECONOMY W AVE uring the past 20 years, Coca-Cola has createdthat too much centralized control has made it slow to respond to D tremendous value for its shareholders. A changing circumstances and insensitive to differences among $10,000 investment in Coke stock in January 1980 would have the various local markets it serves. grown to nearly $600,000 by mid-1998. A large part of that im- Coke’s CEO, Douglas N. Daft, reﬂected these concerns in a re- pressive growth was due to Coke’s overseas expansion program.cent editorial that was published in the March 27, 2000, edi- Today nearly 75 percent of Coke’s proﬁt comes from overseas, tion of Financial Times. Daft’s concluding comments appear and Coke sells roughly half of the world’s soft drinks. below: More recently, Coke has discovered that there are also risks So overall, we will draw on a long-standing belief that Coca- when investing overseas. Indeed, between mid-1998 and Janu- Cola always ﬂourishes when our people are allowed to use ary 2001, Coke’s stock fell by roughtly a third—which means their insight to build the business in ways best suited to that the $600,000 stock investment decreased in value to their local culture and business conditions. $400,000 in about 2.5 years. Coke’s poor performance during We will, of course, maintain clear order. Our small corpo- this period was due in large part to troubles overseas. Weak rate team will communicate explicitly the clear strategy, pol- economic conditions in Brazil, Germany, Japan, Southeast Asia, icy, values, and quality standards needed to keep us cohe- Venezuela, Colombia, and Russia, plus a quality scare in Bel- sive and efﬁcient. But just as important, we will also make gium and France, hurt the company’s bottom line. sure we stay out of the way of our local people and let them Despite its recent difﬁculties, Coke remains committed to its do their jobs. That will enhance signiﬁcantly our ability to global vision. Coke is also striving to learn from these difﬁcul-unlock growth opportunities, which will enable us to consis- ties. The company’s leaders have acknowledged that Coke may tently meet our growth expectations. have become overly centralized. Centralized control enabled Coke In our recent past, we succeeded because we understood to standardize quality and to capture operating efﬁciencies, bothand appealed to global commonalties. In our future, we’ll of which initially helped to establish its brand name throughout succeed because we will also understand and appeal to local the world. More recently, however, Coke has become concerned differences. The 21st century demands nothing less. necessarily exist for many U.S. corporations. As a result of these four factors, survival requires that most manufacturers produce and sell globally. For more information Service companies, including banks, advertising agencies, and accounting about the Coca-Cola ﬁrms,arealsobeingforcedto“goglobal,”becausetheseﬁrmscanbestservetheir Company, go to http://www.thecoca- multinational clients if they have worldwide operations. There will, of course, al- colacompany.com/world/ ways be some purely domestic companies, but the most dynamic growth, and the index.html, where you can ﬁnd proﬁlebestemploymentopportunities,areoftenwithcompaniesthatoperateworldwide. of Coca-Cola’s presence in foreign countries. You may follow additional Even businesses that operate exclusively in the United States are not immune links to Coca-Cola web sites in foreignthe effects of globalization. For example, the costs to a homebuilder in rural countries. Nebraskaareaffectedbyinterestratesandlumberprices — bothofwhicharede- terminedbyworldwidesupplyanddemandconditions.Furthermore,demandfor the homebuilder’s houses is inﬂuenced by interest rates and also by conditions in the local farm economy, which depend to a large extent on foreign demand for wheat.Tooperateefﬁciently,theNebraskabuildermustbeabletoforecastthede- mandforhouses,andthatdemanddependsonworldwideevents.So,atleastsome knowledge of global economic conditions is important to virtually everyone, not just to those involved with businesses that operate internationally. I NFORMATION T ECHNOLOGY As we advance into the new millennium, we will see continued advances in com- puter and communications technology, and this will continue to revolutionize the way ﬁnancial decisions are made. Companies are linking networks of personal 8 CHAPTER 1 I AN OVERVIEW OF FINANCIAL MANAGEMENT eTOYS TAKES ON TOYS “ ” US R he toy market illustrates how electronic commerce is chang- coming from online sales. Indeed, online sales do appear to T ing the way ﬁrms operate. Over the past decade, this market be here to stay. For many customers, online shopping is has been dominated by Toys “ ” Us, although Toys “ ” Us has quicker and more convenient, particularly for working parents faced increasing competition from retail chains such as Wal- of young children, who purchase the lion’s share of toys. From Mart, Kmart, and Target. Then, in 1997, Internet startup eToys the company’s perspective, Internet commerce has a number Inc. began selling and distributing toys through the Internet. of other advantages. The costs of maintaining a web site and When eToys ﬁrst emerged, many analysts believed that the distributing toys online may be smaller than the costs of Internet provided toy retailers with a sensational opportunity.maintaining and managing 1,500 retail stores. This point was made amazingly clear in May 1999 when eToys Not surprisingly, Toys “” Us did not sit idly by — it re- issued stock to the public in an initial public offering (IPO).cently announced plans to invest $64 million in a separate on- The stock immediately rose from its $20 offering price to $76 line subsidiary, Toysrus.com. The company also announced an per share, and the company’s market capitalization (calculated online partnership with Internet retailer Amazon.com. In addi- by multiplying stock price by the number of shares outstanding)tion, Toys “” Us is redoubling its efforts to make traditional was a mind-blowing $7.8 billion. store shopping more enjoyable and less frustrating. To put this valuation in perspective, eToys’ market value at While the Internet provides toy companies with new and in- the time of the offering ($7.8 billion) was 35 percent greater teresting opportunities, these companies also face tremendous than that of Toys “ ” Us ($5.7 billion). eToys’ valuation was risks as they try to respond to the changing technology. In- particularly startling given that the company had yet to earn adeed, in the months following eToys’ IPO, ToysR“Us’ stock fell ” proﬁt. (It lost $73 million in the year ending March 1999.) sharply, and by January 2000, its market value was only slightly Moreover, while Toys “ ” Us had nearly 1,500 stores and rev- above $2 billion. Since then, Toys ” Us stock has rebounded, enues in excess of $11 billion, eToys had no stores and rev- and its market capitalization was once again approaching $5 bil- enues of less than $35 million. lion. The shareholders of eToys were less fortunate. Concerns Investors were clearly expecting that an increasing number about inventory management during the 1999 holiday season of toys will be bought over the Internet. One analyst esti- and the collapse of many Internet stocks spurred a tremendous mated at the time of the offering that eToys would be worth collapse in eToys’ stock — its stock fell from a post–IPO high $10 billion within a decade. His analysis assumed that in 10 of $76 a share to $0.31 a share in January 2001. Two months years the toy market would total $75 billion, with $20 billion later, eToys declared bankruptcy. computers to one another, to the ﬁrms’ own mainframe computers, to the Inter- net and the World Wide Web, and to their customers’ and suppliers’ computers. Thus, ﬁnancial managers are increasingly able to share information and to have “face-to-face” meetings with distant colleagues through video teleconferencing. The ability to access and analyze data on a real-time basis also means that quan- titative analysis is becoming more important, and “gut feel” less sufﬁcient, in business decisions. As a result, the next generation of ﬁnancial managers will need stronger computer and quantitative skills than were required in the past. Changing technology provides both opportunities and threats. Improved technology enables businesses to reduce costs and expand markets. At the same time, however, changing technology can introduce additional competition, which may reduce proﬁtability in existing markets. The banking industry provides a good example of the double-edged technol- ogy sword. Improved technology has allowed banks to process information much more efﬁciently, which reduces the costs of processing checks, providing credit, and identifying bad credit risks. Technology has also allowed banks to serve customers better. For example, today bank customers use automatic teller machines (ATMs) everywhere, from the supermarket to the local mall. Today, FINANCIAL MANAGEMENT IN THE NEW MILLENNIUM 9 many banks also offer products that allow their customers to use the Internet to manage their accounts and to pay bills. However, changing technology also threatens banks’ proﬁtability. Many customers no longer feel compelled to use a local bank, and the Internet allows them to shop worldwide for the best deposit and loan rates. An even greater threat is the continued development of elec- tronic commerce. Electronic commerce allows customers and businesses to transact directly, thus reducing the need for intermediaries such as commercial banks. In the years ahead, ﬁnancial managers will have to continue to keep abreast of technological developments, and they must be prepared to adapt their businesses to the changing environment. SELF-TEST QUESTIONS What two key trends are becoming increasingly important in ﬁnancial man- agement today? How has ﬁnancial management changed from the early 1900s to the present? How might a person become better prepared for a career in ﬁnancial man- agement? THE FINANCIAL STAFF’S RESPONSIBILITIES The ﬁnancial staff’s task is to acquire and then help operate resources so as to maximize the value of the ﬁrm. Here are some speciﬁc activities: 1. Forecasting and planning. The ﬁnancial staff must coordinate the plan- ning process. This means they must interact with people from other de- partments as they look ahead and lay the plans that will shape the ﬁrm’s future. 2. Major investment and financing decisions. A successful firm usually has rapid growth in sales, which requires investments in plant, equip- ment, and inventory. The financial staff must help determine the optimal sales growth rate, help decide what specific assets to acquire, and then choose the best way to finance those assets. For example, should the firm finance with debt, equity, or some combination of the two, and if debt is used, how much should be long term and how much short term? 3. Coordination and control. The ﬁnancial staff must interact with other personnel to ensure that the ﬁrm is operated as efﬁciently as possible. All business decisions have ﬁnancial implications, and all managers — ﬁnan- cial and otherwise — need to take this into account. For example, mar- keting decisions affect sales growth, which in turn inﬂuences investment requirements. Thus, marketing decision makers must take account of how their actions affect and are affected by such factors as the availability of funds, inventory policies, and plant capacity utilization. 4. Dealing with the ﬁnancial markets. The ﬁnancial staff must deal with the money and capital markets. As we shall see in Chapter 5, each ﬁrm af- fects and is affected by the general ﬁnancial markets where funds are 10 CHAPTER 1 I AN OVERVIEW OF FINANCIAL MANAGEMENT raised, where the ﬁrm’s securities are traded, and where investors either make or lose money. 5. Risk management. All businesses face risks, including natural disasters such as fires and floods, uncertainties in commodity and security mar- kets, volatile interest rates, and fluctuating foreign exchange rates. However, many of these risks can be reduced by purchasing insurance or by hedging in the derivatives markets. The financial staff is respon- sible for the firm’s overall risk management program, including identi- fying the risks that should be managed and then managing them in the most efficient manner. In summary, people working in ﬁnancial management make decisions regarding which assets their ﬁrms should acquire, how those assets should be ﬁnanced, and how the ﬁrm should conduct its operations. If these responsibilities are per- formed optimally, ﬁnancial managers will help to maximize the values of their ﬁrms, and this will also contribute to the welfare of consumers and employees. SELF-TEST QUESTION What are some speciﬁc activities with which a ﬁrm’s ﬁnance staff is involved? ALTERNATIVE FORMS OF BUSINESS ORGANIZATION There are three main forms of business organization: (1) sole proprietorships, (2) partnerships, and (3) corporations, plus several hybrid forms. In terms of numbers, about 80 percent of businesses are operated as sole proprietorships, while most of the remainder are divided equally between partnerships and cor- porations. Based on the dollar value of sales, however, about 80 percent of all business is conducted by corporations, about 13 percent by sole proprietor- ships, and about 7 percent by partnerships and hybrids. Because most business is conducted by corporations, we will concentrate on them in this book. How- ever, it is important to understand the differences among the various forms. S OLE PROPRIETORSHIP Sole Proprietorship A sole proprietorship is an unincorporated business owned by one individual. An unincorporated business Going into business as a sole proprietor is easy — one merely begins business owned by one individual. operations. However, even the smallest businesses normally must be licensed by a governmental unit. The proprietorship has three important advantages: (1) It is easily and inex- pensively formed, (2) it is subject to few government regulations, and (3) the business avoids corporate income taxes. The proprietorship also has three important limitations: (1) It is difﬁcult for a proprietorship to obtain large sums of capital; (2) the proprietor has unlim- ited personal liability for the business’s debts, which can result in losses that ALTERNATIVE FORMS OF BUSINESS ORGANIZATION 11 exceed the money he or she has invested in the company; and (3) the life of a business organized as a proprietorship is limited to the life of the individual who created it. For these three reasons, sole proprietorships are used primar- ily for small-business operations. However, businesses are frequently started as proprietorships and then converted to corporations when their growth causes the disadvantages of being a proprietorship to outweigh the advantages. P ARTNERSHIP Partnership A partnership exists whenever two or more persons associate to conduct a An unincorporated business noncorporate business. Partnerships may operate under different degrees of owned by two or more persons. formality, ranging from informal, oral understandings to formal agreements ﬁled with the secretary of the state in which the partnership was formed. The major advantage of a partnership is its low cost and ease of formation. The disadvantages are similar to those associated with proprietorships: (1) unlim- ited liability, (2) limited life of the organization, (3) difﬁculty of transferring ownership, and (4) difﬁculty of raising large amounts of capital. The tax treat- ment of a partnership is similar to that for proprietorships, which is often an advantage, as we demonstrate in Chapter 2. Regarding liability, the partners can potentially lose all of their personal as- sets, even assets not invested in the business, because under partnership law, each partner is liable for the business’s debts. Therefore, if any partner is un- able to meet his or her pro rata liability in the event the partnership goes bank- rupt, the remaining partners must make good on the unsatisﬁed claims, draw- ing on their personal assets to the extent necessary. The partners of the national accounting ﬁrm Laventhol and Horwath, a huge partnership that went bank- rupt as a result of suits ﬁled by investors who relied on faulty audit statements, learned all about the perils of doing business as a partnership. Thus, a Texas partner who audits a business that goes under can bring ruin to a millionaire New York partner who never went near the client company. The ﬁrst three disadvantages — unlimited liability, impermanence of the or- ganization, and difﬁculty of transferring ownership — lead to the fourth, the difﬁculty partnerships have in attracting substantial amounts of capital. This is generally not a problem for a slow-growing business, but if a business’s prod- ucts or services really catch on, and if it needs to raise large amounts of capital to capitalize on its opportunities, the difﬁculty in attracting capital becomes a real drawback. Thus, growth companies such as Hewlett-Packard and Mi- crosoft generally begin life as a proprietorship or partnership, but at some point their founders ﬁnd it necessary to convert to a corporation. C ORPORATION Corporation A corporation is a legal entity created by a state, and it is separate and distinct A legal entity created by a state, from its owners and managers. This separateness gives the corporation three separate and distinct from its major advantages: (1) Unlimited life. A corporation can continue after its origi- owners and managers, having nal owners and managers are deceased. (2) Easy transferability of ownership inter- unlimited life, easy transferabilitest. Ownership interests can be divided into shares of stock, which, in turn, can of ownership, and limited liabilitybe transferred far more easily than can proprietorship or partnership interests. (3) Limited liability. Losses are limited to the actual funds invested. To illustrate limited liability, suppose you invested $10,000 in a partnership that then went 12 CHAPTER 1 I AN OVERVIEW OF FINANCIAL MANAGEMENT bankrupt, owing $1 million. Because the owners are liable for the debts of a partnership, you could be assessed for a share of the company’s debt, and you could be held liable for the entire $1 million if your partners could not pay their shares. Thus, an investor in a partnership is exposed to unlimited liability. On the other hand, if you invested $10,000 in the stock of a corporation that then went bankrupt, your potential loss on the investment would be limited to your $10,000 investment. These three factors — unlimited life, easy transfer- ability of ownership interest, and limited liability — make it much easier for corporations than for proprietorships or partnerships to raise money in the capital markets. The corporate form offers signiﬁcant advantages over proprietorships and partnerships, but it also has two disadvantages: (1) Corporate earnings may be subject to double taxation — the earnings of the corporation are taxed at the corporate level, and then any earnings paid out as dividends are taxed again as income to the stockholders. (2) Setting up a corporation, and ﬁling the many required state and federal reports, is more complex and time-consuming than for a proprietorship or a partnership. A proprietorship or a partnership can commence operations without much paperwork, but setting up a corporation requires that the incorporators prepare a charter and a set of bylaws. Although personal computer software that creates charters and bylaws is now available, a lawyer is required if the ﬂedgling cor- poration has any nonstandard features. The charter includes the following in- formation: (1) name of the proposed corporation, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of directors, and (5) names and addresses of directors. The charter is ﬁled with the secretary of the state in which the ﬁrm will be incorporated, and when it is approved, the corporation 3 is ofﬁcially in existence. Then, after the corporation is in operation, quarterly and annual employment, ﬁnancial, and tax reports must be ﬁled with state and federal authorities. The bylaws are a set of rules drawn up by the founders of the corporation. In- cluded are such points as (1) how directors are to be elected (all elected each year, or perhaps one-third each year for three-year terms); (2) whether the existing stockholders will have the ﬁrst right to buy any new shares the ﬁrm issues; and (3) procedures for changing the bylaws themselves, should conditions require it. The value of any business other than a very small one will probably be max- imized if it is organized as a corporation for the following three reasons: 1. Limited liability reduces the risks borne by investors, and, other things held constant, the lower the ﬁrm’s risk, the higher its value. 2. A ﬁrm’s value is dependent on its growth opportunities, which in turn are dependent on the ﬁrm’s ability to attract capital. Since corporations can attract capital more easily than can unincorporated businesses, they are better able to take advantage of growth opportunities. 2In the case of small corporations, the limited liability feature is often a ﬁction, because bankers and other lenders frequently require personal guarantees from the stockholders of small, weak busi- 3esses. Note that more than 60 percent of major U.S. corporations are chartered in Delaware, which has, over the years, provided a favorable legal environment for corporations. It is not necessary for a ﬁrm to be headquartered, or even to conduct operations, in its state of incorporation.
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