Fundamentals of Corporate Finance - Third Edition PDF

 Selected material from Fundamentals of Corporate Finance Third Edition Richard A. Brealey Bank of England and London Business School Stewart C. Myers...

 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. Ex- cept as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distrib- uted in any form or by any means, or stored in a data base retrieval system, without prior written permission of the pub- lisher. 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 SECTION 1 1 The Firm and the Financial How to Value Perpetuities 50 How to Value Annuities 51 Manager 3 Annuities Due 54 Organizing a Business 4 Future Value of an Annuity 57 Sole Proprietorships 4 Inflation and the Time Value of Money 61 Partnerships 5 Real versus Nominal Cash Flows 61 Corporations 5 Inflation and Interest Rates 63 Hybrid Forms of Business Organization 6 Valuing Real Cash Payments 65 The Role of the Financial Manager 7 Real or Nominal? 67 The Capital Budgeting Decision 8 Effective Annual Interest Rates 67 The Financing Decision 9 Summary 69 Financial Institutions and Markets 10 Related Web Links 69 Financial Institutions 10 Key Terms 70 Financial Markets 11 Quiz 70 Other Functions of Financial Markets and Practice Problems 72 Institutions 12 Challenge Problems 75 Who Is the Financial Manager? 13 Solutions to Self-Test Questions 77 Careers in Finance 15 Minicase 79 Goals of the Corporation 17 Financial Planning 81 Shareholders Want Managers to Maximize What Is Financial Planning? 82 Market Value 17 Financial Planning Focuses on the Big Picture 83 Ethics and Management Objectives 19 Financial Planning Is Not Just Forecasting 84 Do Managers Really Maximize Firm Value? 21 Three Requirements for Effective Planning 84 Snippets of History 25 Financial Planning Models 86 Summary 25 Components of a Financial Planning Model 87 Related Web Links 28 An Example of a Planning Model 88 Key Terms 28 An Improved Model 89 Quiz 28 Practice Problems 29 Planners Beware 93 Solutions to Self-Test Questions 31 Pitfalls in Model Design 93 The Assumption in Percentage of Sales Models 94 The Time Value of Money 33 The Role of Financial Planning Models 95 Future Values and Compound Interest 34 External Financing and Growth 96 Present Values 38 Summary 100 Finding the Interest Rate 44 Related Web Links 101 Multiple Cash Flows 46 Key Terms 101 Future Value of Multiple Cash Flows 46 Quiz 101 Present Value of Multiple Cash Flows 49 Practice Problems 102 Challenge Problems 106 Level Cash Flows: Perpetuities and Annuities 50 Solutions to Self-Test Questions 106 iii IV CONTENTS APPENDIX A 109 Financial Statement Analysis 133 Accounting and Finance 111 Financial Ratios 134 The Balance Sheet 112 Leverage Ratios 138 Book Values and Market Values 115 Liquidity Ratios 139 Efficiency Ratios 141 The Income Statement 117 Profitability Ratios 143 Profits versus Cash Flow 118 The Du Pont System 145 The Statement of Cash Flows 119 Other Financial Ratios 146 Accounting for Differences 121 Using Financial Ratios 147 Taxes 123 Choosing a Benchmark 147 Corporate Tax 123 Measuring Company Performance 150 Personal Tax 125 The Role of Financial Ratios 151 Summary 126 Related Web Links 127 Summary 153 Key Terms 127 Related Web Links 155 Quiz 127 Key Terms 155 Practice Problems 128 Quiz 155 Challenge Problem 131 Practice Problems 157 Solutions to Self-Test Questions 131 Challenge Problem 158 Solutions to Self-Test Questions 159 Minicase 160 SECTION 2 163 Working Capital Management and Bank Loans 185 Commercial Paper 186 Short-Term Planning 165 Secured Loans 186 Working Capital 167 The Cost of Bank Loans 187 The Components of Working Capital 167 Simple Interest 187 Working Capital and the Cash Conversion Cycle 168 Discount Interest 188 The Working Capital Trade-Off 171 Interest with Compensating Balances 189 Links between Long-Term and Short-Term Summary 190 Financing 172 Related Web Links 191 Tracing Changes in Cash and Working Capital 175 Key Terms 191 Quiz 191 Cash Budgeting 177 Practice Problems 192 Forecast Sources of Cash 177 Challenge Problem 194 Forecast Uses of Cash 179 Solutions to Self-Test Questions 195 The Cash Balance 179 Minicase 197 A Short-Term Financing Plan 180 Options for Short-Term Financing 180 Cash and Inventory Management 201 Evaluating the Plan 184 Cash Collection, Disbursement, and Float 202 Float 203 Sources of Short-Term Financing 185 Valuing Float 204  CONTENTS V Managing Float 205 Credit Analysis 232 Speeding Up Collections 206 Financial Ratio Analysis 233 Controlling Disbursements 209 Numerical Credit Scoring 233 Electronic Funds Transfer 210 When to Stop Looking for Clues 234 Inventories and Cash Balances 211 The Credit Decision 236 Managing Inventories 212 Credit Decisions with Repeat Orders 237 Managing Inventories of Cash 215 Some General Principles 238 Uncertain Cash Flows 216 Collection Policy 239 Cash Management in the Largest Corporations 217 Investing Idle Cash: The Money Market 218 Bankruptcy 240 Bankruptcy Procedures 241 Summary 219 The Choice between Liquidation and Related Web Links 220 Reorganization 242 Key Terms 220 Quiz 220 Summary 244 Practice Problems 221 Related Web Links 245 Challenge Problem 224 Key Terms 245 Solutions to Self-Test Questions 224 Quiz 245 Practice Problems 246 Credit Management and Collection 227 Challenge Problems 248 Terms of Sale 229 Solutions to Self-Test Questions 249 Minicase 250 Credit Agreements 231 SECTION 3 253 Valuing Bonds 255 Book Values, Liquidation Values, and Market Values 283 Bond Characteristics 256 Reading the Financial Pages 257 Valuing Common Stocks 287 Today’s Price and Tomorrow’s Price 287 Bond Prices and Yields 259 The Dividend Discount Model 288 How Bond Prices Vary with Interest Rates 260 Yield to Maturity versus Current Yield 261 Simplifying the Dividend Discount Model 291 Rate of Return 265 The Dividend Discount Model with No Growth 291 Interest Rate Risk 267 The Constant-Growth Dividend Discount Model 292 The Yield Curve 268 Estimating Expected Rates of Return 293 Nominal and Real Rates of Interest 268 Nonconstant Growth 295 Default Risk 270 Growth Stocks and Income Stocks 296 Valuations in Corporate Bonds 273 The Price-Earnings Ratio 298 Summary 273 What Do Earnings Mean? 298 Related Web Links 274 Valuing Entire Businesses 301 Key Terms 274 Summary 301 Quiz 274 Related Web Links 302 Practice Problems 275 Key Terms 302 Challenge Problems 277 Quiz 302 Solutions to Self-Test Questions 277 Practice Problems 303 Valuing Stocks 279 Challenge Problems 306 Solutions to Self-Test Questions 307 Stocks and the Stock Market 280 Reading the Stock Market Listings 281 VI CONTENTS Introduction to Risk, Return, and the Risk and Diversification 324 Diversification 324 Opportunity Cost of Capital 311 Asset versus Portfolio Risk 325 Rates of Return: A Review 312 Market Risk versus Unique Risk 330 Seventy-Three Years of Capital Market Thinking about Risk 331 History 313 Message 1: Some Risks Look Big and Dangerous but Market Indexes 314 Really Are Diversifiable 331 The Historical Record 314 Message 2: Market Risks Are Macro Risks 332 Using Historical Evidence to Estimate Today’s Cost of Message 3: Risk Can Be Measured 333 Capital 317 Summary 334 Measuring Risk 318 Related Web Links 334 Variance and Standard Deviation 318 Key Terms 334 A Note on Calculating Variance 322 Quiz 335 Measuring the Variation in Stock Returns 322 Practice Problems 336 Solutions to Self-Test Questions 338 SECTION 4 339 Net Present Value and Other Investment Challenge Problems 373 Solutions to Self-Test Questions 373 Criteria 341 Net Present Value 343 Using Discounted Cash-Flow Analysis to A Comment on Risk and Present Value 344 Make Investment Decisions 377 Valuing Long-Lived Projects 345 Discount Cash Flows, Not Profits 379 Other Investment Criteria 349 Discount Incremental Cash Flows 381 Internal Rate of Return 349 Include All Indirect Effects 381 A Closer Look at the Rate of Return Rule 350 Forget Sunk Costs 382 Calculating the Rate of Return for Long-Lived Include Opportunity Costs 382 Projects 351 Recognize the Investment in Working Capital 383 A Word of Caution 352 Beware of Allocated Overhead Costs 384 Payback 352 Book Rate of Return 355 Discount Nominal Cash Flows by the Nominal Cost of Capital 385 Investment Criteria When Projects Interact 356 Mutually Exclusive Projects 356 Separate Investment and Financing Decisions 386 Investment Timing 357 Calculating Cash Flow 387 Long- versus Short-Lived Equipment 359 Capital Investment 387 Replacing an Old Machine 361 Investment in Working Capital 387 Mutually Exclusive Projects and the IRR Rule 361 Cash Flow from Operations 388 Other Pitfalls of the IRR Rule 363 Example: Blooper Industries 390 Capital Rationing 365 Calculating Blooper’s Project Cash Flows 391 Soft Rationing 365 Calculating the NPV of Blooper’s Project 392 Hard Rationing 366 Further Notes and Wrinkles Arising from Blooper’s Pitfalls of the Profitability Index 3667 Project 393 Summary 367 Summary 397 Related Web Links 368 Related Web Links 398 Key Terms 368 Key Terms 398 Quiz 368 Quiz 398 Practice Problems 369  CONTENTS VII Practice Problems 200 Calculating Company Cost of Capital as a Weighted Challenge Problems 402 Average 440 Solutions to Spreadsheet Model Questions 403 Market versus Book Weights 441 Solutions to Self-Test Questions 404 Taxes and the Weighted-Average Cost of Capital 442 Minicase 405 What If There Are Three (or More) Sources of Financing? 443 Risk, Return, and Capital Budgeting 407 Wrapping Up Geothermal 444 Measuring Market Risk 408 Checking Our Logic 445 Measuring Beta 409 Measuring Capital Structure 446 Betas for MCI WorldCom and Exxon 411 Portfolio Betas 412 Calculating Required Rates of Return 447 The Expected Return on Bonds 448 Risk and Return 414 The Expected Return on Common Stock 448 Why the CAPM Works 416 The Expected Return on Preferred Stock 449 The Security Market Line 417 How Well Does the CAPM Work? 419 Big Oil’s Weighted-Average Cost of Capital 450 Using the CAPM to Estimate Expected Returns 420 Real Oil Company WACCs 450 Capital Budgeting and Project Risk 422 Interpreting the Weighted-Average Cost of Company versus Project Risk 422 Capital 451 Determinants of Project Risk 423 When You Can and Can’t Use WACC 451 Don’t Add Fudge Factors to Discount Rates 424 Some Common Mistakes 452 How Changing Capital Structure Affects Expected Summary 425 Returns 452 Related Web Links 426 What Happens When the Corporate Tax Rate Is Not Key Terms 426 Zero 453 Quiz 426 Practice Problems 427 Flotation Costs and the Cost of Capital 454 Challenge Problem 432 Summary 454 Solutions to Self-Test Questions 432 Related Web Links 455 Key Terms 455 The Cost of Capital 435 Quiz 455 Geothermal’s Cost of Capital 436 Practice Problems 456 Challenge Problems 458 Calculating the Weighted-Average Cost of Solutions to Self-Test Questions 458 Capital 438 Minicase 459 SECTION 5 463 Project Analysis 465 NPV Break-Even Analysis 475 Operating Leverage 478 How Firms Organize the Investment Process 466 Stage 1: The Capital Budget 467 Flexibility in Capital Budgeting 481 Stage 2: Project Authorizations 467 Decision Trees 481 Problems and Some Solutions 468 The Option to Expand 482 Abandonment Options 483 Some “What-If ” Questions 469 Flexible Production Facilities 484 Sensitivity Analysis 469 Investment Timing Options 484 Scenario Analysis 472 Summary 485 Break-Even Analysis 473 Related Web Links 485 Accounting Break-Even Analysis 474 Key Terms 485 VIII CONTENTS Quiz 485 Quiz 512 Practice Problems 486 Practice Problems 513 Challenge Problems 489 Solutions to Self-Test Questions 514 Solutions to Self-Test Questions 489 Minicase 491 How Corporations Issue Securities 517 Venture Capital 519 An Overview of Corporate Financing 493 The Initial Public Offering 520 Arranging a Public Issue 521 Common Stock 494 Book Value versus Market Value 496 The Underwriters 526 Dividends 497 Who Are the Underwriters? 526 Stockholders’ Rights 497 General Cash Offers by Public Companies 528 Voting Procedures 497 General Cash Offers and Shelf Registration 528 Classes of Stock 498 Costs of the General Cash Offer 529 Corporate Governance in the United States and Market Reaction to Stock Issues 530 Elsewhere 498 The Private Placement 531 Preferred Stock 499 Summary 532 Corporate Debt 500 Related Web Links 533 Debt Comes in Many Forms 501 Key Terms 533 Innovation in the Debt Market 504 Quiz 534 Convertible Securities 507 Practice Problems 534 Challenge Problem 536 Patterns of Corporate Financing 508 Solutions to Self-Test Questions 537 Do Firms Rely Too Heavily on Internal Funds? 508 Minicase 537 External Sources of Capital 510 Appendix: Hotch Pot’s New Issue Prospectus 539 Summary 511 Related Web Links 512 Key Terms 512 APPENDIX B 545 Leasing 547 Lease or Buy? 555 Leasing versus Buying 548 A Preliminary Analysis 555 Operating Leases 548 Three Potential Pitfalls 555 Financial Leases 549 NPV Analysis 556 Tax-Oriented Leases 549 A Misconception 556 Leveraged Leases 550 Leverage and Capital Structure Sale and Leaseback Agreements 550 559 Accounting and Leasing 550 The Capital Structure Question 560 Taxes, the IRS, and Leases 552 The Effect of Financial Leverage 560 The Impact of Financial Leverage 560 The Cash Flows from Leasing 553 Financial Leverage, EPS, and ROE: The Incremental Cash Flows 553 An Example 561 A Note on Taxes 554 EPS versus EBIT 561  CONTENTS IX SECTION 6 565 Mergers, Acquisitions, and Corporate Related Web Links 592 Key Terms 592 Control 567 Quiz 592 22.1 The Market for Corporate Control 569 Practice Problems 593 Method 1: Proxy Contests 569 Challenge Problems 594 Method 2: Mergers and Acquisitions 570 Solutions to Self-Test Questions 595 Method 3: Leveraged Buyouts 571 Minicase 595 Method 4: Divestitures and Spin-offs 571 International Financial 22.2 Sensible Motives for Mergers 572 Management 597 Economies of Scale 573 23.1 Foreign Exchange Markets 598 Economies of Vertical Integration 573 Combining Complementary Resources 574 23.2 Some Basic Relationships 602 Mergers as a Use for Surplus Funds 574 Exchange Rates and Inflation 602 Inflation and Interest Rates 606 22.3 Dubious Reasons for Mergers 575 Interest Rates and Exchange Rates 608 Diversification 575 The Forward Rate and the Expected Spot Rate 609 The Bootstrap Game 575 Some Implications 610 22.4 Evaluating Mergers 577 23.3 Hedging Exchange Rate Risk 612 Mergers Financed by Cash 577 Mergers Financed by Stock 579 23.4 International Capital Budgeting 613 A Warning 580 Net Present Value Analysis 613 Another Warning 580 The Cost of Capital for Foreign Investment 615 Avoiding Fudge Factors 616 22.5 Merger Tactics 582 Who Gets the Gains? 584 23.5 Summary 617 Related Web Links 618 22.6 Leveraged Buyouts 585 Key Terms 618 Barbarians at the Gate? 587 Quiz 618 22.7 Mergers and the Economy 588 Practice Problems 619 Merger Waves 588 Challenge Problem 621 Do Mergers Generate Net Benefits? 589 Solutions to Self-Test Questions 621 Minicase 623 22.8 Summary 590 APPENDIX C 625 Glossary 635 Section 1 The Firm and the Financial Manager The Time Value of Money Financial Statement Analysis THE FIRM AND THE FINANCIAL MANAGER Organizing a Business Who Is the Financial Sole Proprietorships Manager? Partnerships Careers in Finance Corporations Goals of the Corporation Hybrid Forms of Business Organization Shareholders Want Managers to Maximize Market Value The Role of the Financial Ethics and Management Objectives Manager Do Managers Really Maximize Firm The Capital Budgeting Decision Value? The Financing Decision Snippets of History Financial Institutions and Summary Markets 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  his material is an introduction to corporate finance. We will discuss the T 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 de- cide (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 in- vest 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 intro- duction 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 prof- its? 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 cor- porations 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 stockhold- ers, 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 5 SOLE PROPRIETOR after the Internal Revenue Service has taken its cut. The advantages of a proprietorship Sole owner of a business are the ease with which it can be established and the lack of regulations governing it. which has no partners and This makes it well-suited for a small company with an informal business structure. no shareholders. The As a sole proprietor, you are responsible for all the business’s debts and other liabil- proprietor is personally liable ities. If the business borrows from the bank and subsequently cannot repay the loan, the for all the firm’s obligations. 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 un- limited liability. PARTNERSHIPS 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 PARTNERSHIP decisions are to be made and the proportion of the profits to which each partner is en- Business owned by two or titled. The partners then pay personal income tax on their share of these profits. more persons who are Partners, like sole proprietors, have the disadvantage of unlimited liability. If the busi- personally responsible for all ness runs into financial difficulties, each partner has unlimited liability for all the busi- its liabilities. ness’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 As your firm grows, you may decide to incorporate. Unlike a proprietorship or part- nership, a corporation is legally distinct from its owners. It is based on articles of in- CORPORATION corporation that set out the purpose of the business, how many shares can be issued, the Business owned by number of directors to be appointed, and so on. These articles must conform to the laws stockholders who are not of the state in which the business is incorporated. For many legal purposes, the corpo- personally liable for the ration is considered a resident of its state. For example, it can borrow or lend money, business’s liabilities. 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 mat- ters. Unlike proprietorships or partnerships, corporations have limited liability, which LIMITED LIABILITY means that the stockholders cannot be held personally responsible for the obligations of The owners of the the firm. If, say, IBM were to fail, no one could demand that its shareholders put up corporation are not more money to pay off the debts. The most a stockholder can lose is the amount invested personally responsible for its in the stock. obligations. 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 corpora- tions. 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 flex- ibility 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 share- holders may sell all their shares to new investors without affecting the business. In con- trast, 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 organ- ized 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 cor- porations pay tax on their profits, and, in addition, shareholders pay tax on any divi- dends 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 busi- ness 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 pre- sents 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 un- limited 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 1 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.  The Firm and the Financial Manager 7 TABLE 1.1 Characteristics of Sole business organizations Proprietorship Partnership Corporation Who owns the business? The manager Partners Shareholders Are managers and owner(s) No No Usually separate? What is the owner’s Unlimited Unlimited Limited liability? Are the owner and business No No Yes taxed separately? partners have limited liability. This form of business organization combines the tax ad- vantage of partnership with the limited liability advantage of incorporation. However, it still does not suit the largest firms, for which widespread share ownership and sepa- ration of ownership and management are essential. Another variation on the theme is the professional corporation (PC), which is com- monly 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 To carry on business, companies need an almost endless variety of real assets. Many of REAL ASSETS Assets these assets are tangible, such as machinery, factories, and offices; others are intangi- used to produce goods and ble, such as technical expertise, trademarks, and patents. All of them must be paid for. services. 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 FINANCIAL ASSETS the cash that those assets will produce. For example, if the company borrows money Claims to the income from the bank, the bank has a financial asset. That financial asset gives it a claim to a generated by real assets. Also called securities. 3 For present purposes we are using financial assets and securities interchangeably, though “securities” usu- ally 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 peo- ple would not think of it as a security. 8 SECTION ONE FIGURE 1.1 Flow of cash between capital markets and the firm’s (2) (1) Firm’s Financial operations. Key: (1) Cash operations markets Financial manager (4a) raised by selling financial (a bundle (investors holding assets to investors; (2) cash of real assets) (3) (4b) financial assets) invested in the firm’s operations; (3) cash generated by the firm’s operations; (4a) cash reinvested; (4b) cash returned to investors. 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 FINANCIAL MARKETS in which the firm raises cash. The financial manager’s role is shown in Figure 1.1, Markets in which financial which traces how money flows from investors to the firm and back to investors again. assets are traded. 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 in- terest 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 in- vest in? This is the firm’s investment, or capital budgeting, decision. Second, how CAPITAL BUDGETING should the cash required for an investment be raised? This is the financing decision. DECISION Decision as to which real assets the firm should acquire. THE CAPITAL BUDGETING DECISION Capital budgeting decisions are central to the company’s success or failure. For exam- FINANCING DECISION ple, in the late 1980s, the Walt Disney Company committed to construction of a Dis- Decision as to how to raise neyland Paris theme park at a total cost of well over $2 billion. The park, which opened the money to pay for in 1992, turned out to be a financial bust, and Euro Disney had to reorganize in May investments in real assets. 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 there- fore 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 manufac- turing 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 dis- mal failure. The financial manager needs a way to place a value on these uncertain fu- ture 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 pro- posals will weight the odds in your favor. THE FINANCING DECISION The financial manager’s second responsibility is to raise the money to pay for the in- vestment in real assets. This is the financing decision. When a company needs financ- ing, it can invite investors to put up cash in return for a share of profits or it can prom- ise 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 sec- ond, the investor becomes a lender who must one day be repaid. The choice of the long- term financing mix is often called the capital structure decision, since capital refers CAPITAL STRUCTURE to the firm’s sources of long-term financing, and the markets for long-term financing Firm’s mix of long-term are called capital markets.5 financing. 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 capital markets for long-term debt financing or should it borrow from a bank? Should Markets for long-term it borrow in Paris, receiving and promising to repay euros, or should it borrow dollars financing. 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. 10 SECTION ONE 䉴 Self-Test 2 Are the following capital budgeting or financing decisions? a. Intel decides to spend $500 million to develop a new microprocessor. b. Volkswagen decides to raise 350 million euros through a bank loan. c. Exxon constructs a pipeline to bring natural gas on shore from the Gulf of Mexico. d. Pierre Lapin sells shares to finance expansion of his newly formed securities trading firm. e. Novartis buys a license to produce and sell a new drug developed by a biotech company. f. Merck issues new shares to help pay for the purchase of Medco, a pharmaceutical distribution company. Financial Institutions and Markets If a corporation needs to borrow from the bank or issue new securities, then its finan- cial manager had better understand how financial markets work. Perhaps less obviously, the capital budgeting decision also requires an understanding of financial markets. We have said that a successful investment is one that increases firm value. But how do in- vestors value a firm? The answer to this question requires a theory of how the firm’s stock is priced in financial markets. Of course, theory is not the end of it. The financial manager is in day-by-day—some- times minute-by-minute—contact with financial markets and must understand their in- stitutions, regulations, and operating practices. We can give you a flavor for these issues by considering briefly some of the ways that firms interact with financial markets and institutions. FINANCIAL INSTITUTIONS Most firms are too small to raise funds by selling stocks or bonds directly to investors. When these companies need to raise funds to help pay for a capital investment, the only FINANCIAL choice is to borrow money from a financial intermediary like a bank or insurance INTERMEDIARY Firm company. The financial intermediary, in turn, raises funds, often in small amounts, from that raises money from many individual households. For example, a bank raises funds when customers deposit money small investors and provides into their bank accounts. The bank can then lend this money to borrowers. financing to businesses or The bank saves borrowers and lenders from finding and negotiating with each other other organizations by directly. For example, a firm that wishes to borrow $2.5 million could in principle try investing in their securities. to arrange loans from many individuals: Issues debt (borrows) Company Investors $2.5 million However, it is far more convenient and efficient for a bank, which has ongoing relations with thousands of depositors, to raise the funds from them, and then lend the money to the company:  The Firm and the Financial Manager 11 Establishes Issues debt Bank deposits Investors and Company (intermediary) depositors $2.5 million Cash The bank provides a service. To cover the costs of this service, it charges borrowers a higher interest rate than it pays its depositors. Banks and their immediate relatives, such as savings and loan companies, are the most familiar financial intermediaries. But there are many others, such as insurance companies. In the United States, insurance companies are more important than banks for the long-term financing of business. They are massive investors in corporate stocks and bonds, and they often make long-term loans directly to corporations. Suppose a company needs a loan for 9 years, not 9 months. It could issue a bond di- rectly to investors, or it could negotiate a 9-year loan with an insurance company: Sells policies; Issues debt Insurance issues stock Investors and Company company policyholders (intermediary) Cash $2.5 million The money to make the loan comes mainly from the sale of insurance policies. Say you buy a fire insurance policy on your home. You pay cash to the insurance company and get a financial asset (the policy) in exchange. You receive no interest payments on this financial asset, but if a fire does strike, the company is obliged to cover the damages up to the policy limit. This is the return on your investment. The company will issue not just one policy, but thousands. Normally the incidence of fires “averages out,” leaving the company with a predictable obligation to its policy- holders as a group. Of course the insurance company must charge enough for its poli- cies to cover selling and administrative costs, pay policyholders’ claims, and generate a profit for its stockholders. Why is a financial intermediary different from a manufacturing corporation? First, it may raise money differently, for example, by taking deposits or selling insurance poli- cies. Second, it invests that money in financial assets, for example, in stocks, bonds, or loans to businesses or individuals. The manufacturing company’s main investments are in plant, equipment, and other real assets. FINANCIAL MARKETS As firms grow, their need for capital can expand dramatically. At some point, the firm may find that “cutting out the middle-man” and raising funds directly from investors is advantageous. At this point, it is ready to sell new financial assets, such as shares of stock, to the public. The first time the firm sells shares to the general public is called the initial public offering, or IPO. The corporation, which until now was privately owned, is said to “go public.” The sale of the securities is usually managed by a group of investment banks such as Goldman Sachs or Merrill Lynch. Investors who buy shares are contributing funds that will be used to pay for the firm’s investments in real assets. In return, they become part-owners of the firm and share in the future success of the en- terprise. Anyone who followed the market for Internet IPOs in 1999 knows that these expectations for future success can be on the optimistic side (to put it mildly). 12 SECTION ONE An IPO is not the only occasion on which newly issued stock is sold to the public. Established firms also issue new shares from time to time. For example, suppose Gen- eral Motors needs to raise funds to renovate an auto plant. It might hire an investment banking firm to sell $500 million of GM stock to investors. Some of this stock may be bought by individuals; the remainder will be bought by financial institutions such as pension funds and insurance companies. In fact, about a quarter of the shares of U.S. companies are owned by pension funds. A new issue of securities increases both the amount of cash held by the company and the amount of stocks or bonds held by the public. Such an issue is known as a primary PRIMARY MARKET issue and it is sold in the primary market. But in addition to helping companies raise Market for the sale of new new cash, financial markets also allow investors to trade stocks or bonds between them- securities by corporations. selves. For example, Smith might decide to raise some cash by selling her AT&T stock at the same time that Jones invests his spare cash in AT&T. The result is simply a trans- fer of ownership from Smith to Jones, which has no effect on the company itself. Such purchases and sales of existing securities are known as secondary transactions and they SECONDARY MARKET take place in the secondary market. Market in which already Some financial assets have no secondary market. For example, when a small com- issued securities are traded pany borrows money from the bank, it gives the bank an IOU promising to repay the among investors. money with interest. The bank will keep the IOU and will not sell it to another bank. Other financial assets are regularly traded. Thus when a large public company raises cash by selling new shares to investors, it knows that many of these investors will sub- sequently decide to sell their shares to others. Most trading in the shares of large United States corporations takes place on stock exchanges such as the New York Stock Exchange (NYSE). There is also a thriving over- the-counter (OTC) market in securities. The over-the-counter market is not a centralized exchange like the NYSE but a network of security dealers who use an electronic sys- tem known as NASDAQ6 to quote prices at which they will buy and sell shares. While shares of stock may be traded either on exchanges or over-the-counter, almost all cor- porate debt is traded over-the-counter, if it is traded at all. United States government debt is also traded over-the-counter. Many other things trade in financial markets, including foreign currencies; claims on commodities such as corn, crude oil, and silver; and options. Now may be a good point to stress that the financial manager plays on a global stage and needs to be familiar with markets around the world. For example, the stock of Citi- corp, one of the largest U.S. banks, is listed in New York, London, Amsterdam, Tokyo, Zurich, Toronto, and Frankfurt, as well as on several smaller exchanges. Conversely, British Airways, Deutsche Telecom, Nestlé, Sony, and nearly 200 other overseas firms have listed their shares on the New York Stock Exchange. OTHER FUNCTIONS OF FINANCIAL MARKETS AND INSTITUTIONS Financial markets and institutions provide financing for business. They also contribute in many other ways to our individual well-being and the smooth functioning of the economy. Here are some examples.7 6 NationalAssociation of Security Dealers Automated Quotation system. 7 RobertMerton gives an excellent overview of these functions in “A Functional Perspective of Financial In- termediation,” Financial Management 24 (Summer 1995), pp. 23–41.  The Firm and the Financial Manager 13 The Payment Mechanism. Think how inconvenient life would be if you had to pay for every purchase in cash or if General Motors had to ship truckloads of hundred-dollar bills round the country to pay its suppliers. Checking accounts, credit cards, and electronic transfers allow individuals and firms to send and receive payments quickly and safely over long distances. Banks are the obvious providers of payment services, but they are not alone. For example, if you buy shares in a money-market mutual fund, your money is pooled with that of other investors and used to buy safe, short-term securities. You can then write checks on this mutual fund investment, just as if you had a bank deposit. Borrowing and Lending. Financial institutions allow individuals to transfer expen- ditures across time. If you have more money now than you need and you wish to save for a rainy day, you can (for example) put the money on deposit in a bank. If you wish to anticipate some of your future income to buy a car, you can borrow money from the bank. Both the lender and the borrower are happier than if they were forced to spend cash as it arrived. Of course, individuals are not alone in needing to raise cash from time to time. Firms with good investment opportunities raise cash by borrowing or selling new shares. Many governments run at a deficit. In principle, individuals or firms with cash surpluses could take out newspaper advertisements or surf the Net looking for counterparts with cash shortages. But it is usually cheaper and more convenient to use financial markets or institutions to link the borrower and the lender. For example, banks are equipped to check the borrower’s creditworthiness and to monitor the use of the cash. Almost all financial institutions are involved in channeling savings toward those who can best use them. Pooling Risk. Financial markets and institutions allow individuals and firms to pool their risks. Insurance companies are an obvious example. Here is another. Suppose that you have only a small sum to invest. You could buy the stock of a single company, but then you could be wiped out if that company went belly-up. It’s generally better to buy shares in a mutual fund that invests in a diversified portfolio of common stocks or other securi- ties. In this case you are exposed only to the risk that security prices as a whole may fall.8 䉴 Self-Test 3 Do you understand the following distinctions? Briefly explain in each case. a. Real versus financial assets. b. Investment versus financing decisions. c. Capital budgeting versus capital structure decisions. d. Primary versus secondary markets. e. Financial intermediation versus direct financing from financial markets. Who Is the Financial Manager? We will use the term financial manager to refer to anyone responsible for a significant corporate investment or financing decision. But except in the smallest firms, no single 8Mutual funds provide other services. For example, they take care of much of the paperwork of holding shares. Investors also hope that the fund’s professional managers will be able to outsmart the market and se- cure higher returns. 14 SECTION ONE FIGURE 1.2 The financial managers in large corporations. Chief Financial Officer (CFO) Responsible for: Financial policy Corporate planning Treasurer Controller Responsible for: Responsible for: Cash management Preparation of financial statements Raising capital Accounting Banking relationships Taxes person is responsible for all the decisions discussed in this book. Responsibility is dis- persed throughout the firm. Top management is of course constantly involved in finan- cial decisions. But the engineer who designs a new production facility is also involved: the design determines the kind of asset the firm will invest in. Likewise the marketing manager who undertakes a major advertising campaign is making an investment deci- sion: the campaign is an investment in an intangible asset that will pay off in future sales and earnings. Nevertheless, there are managers who specialize in finance, and their functions are TREASURER Manager summarized in Figure 1.2. The treasurer is usually the person most directly responsi- responsible for financing, ble for looking after the firm’s cash, raising new capital, and maintaining relationships cash management, and with banks and other investors who hold the firm’s securities. relationships with financial For small firms, the treasurer is likely to be the only financial executive. Larger cor- markets and institutions. porations usually also have a controller, who prepares the financial statements, man- ages the firm’s internal accounting, and looks after its tax affairs. You can see that the CONTROLLER Officer treasurer and controller have different roles: the treasurer’s main function is to obtain responsible for budgeting, and manage the firm’s capital, whereas the controller ensures that the money is used ef- accounting, and auditing. ficiently. The largest firms usually appoint a chief financial officer (CFO) to oversee both CHIEF FINANCIAL the treasurer’s and the controller’s work. The CFO is deeply involved in financial poli- OFFICER (CFO) Officer cymaking and corporate planning. Often he or she will have general responsibilities be- who oversees the treasurer yond strictly financial issues. and controller and sets Usually the treasurer, controller, or CFO is responsible for organizing and supervis- overall financial strategy. ing the capital budgeting process. However, major capital investment projects are so closely tied to plans for product development, production, and marketing that managers from these other areas are inevitably drawn into planning and analyzing the projects. If the firm has staff members specializing in corporate planning, they are naturally in- volved in capital budgeting too. Because of the importance of many financial issues, ultimate decisions often rest by law or by custom with the board of directors.9 For example, only the board has the legal power to declare a dividend or to sanction a public issue of securities. Boards usually delegate decision-making authority for small- or medium-sized investment outlays, but the authority to approve large investments is almost never delegated. 9 Often the firm’s chief financial officer is also a member of its board of directors.  The Firm and the Financial Manager 15 䉴 Self-Test 4 Sal and Sally went to business school together 10 years ago. They have just been hired by a midsized corporation that wants to bring in new financial managers. Sal studied fi- nance, with an emphasis on financial markets and institutions. Sally majored in ac- counting and became a CPA 5 years ago. Who is more suited to be treasurer and who controller? Briefly explain. CAREERS IN FINANCE In the United States well over 1 million people work in financial services, and many oth- ers work in the finance departments of corporations. We can’t tell you what each person does all day, but we can give you some idea of the variety of careers in finance. The SEE BOX nearby box summarizes the experience of a small sample of recent (fictitious) graduates. We explained earlier that corporations face two principal financial decisions: the in- vestment decision and the financing decision. Therefore, as a newly recruited financial analyst, you may help to analyze a major new investment project. Or you may instead help to raise the money to pay for it, perhaps by a new issue of debt or by arranging to lease the plant and equipment. Other financial analysts work on short-term financial is- sues, such as collecting and investing the company’s cash or checking whether cus- tomers are likely to pay their bills. Financial analysts are also involved in monitoring and controlling risk. For example, they may help to arrange insurance for the firm’s plant and equipment, or they may assist with the purchase and sale of options, futures, and other exotic tools for managing risk. Instead of working in the finance department of a corporation, you may join a fi- nancial institution. The largest employers are the commercial banks. We noted earlier that banks collect deposits and relend the cash to corporations and individuals. If you join a bank, at some point you may well work in a branch, where individuals and small businesses come to deposit cash or to seek a loan. Alternatively, you may be employed in the head office, helping to analyze a $100 million loan to a large corporation. Banks do many things in addition to lending money, and they probably provide a greater variety of jobs than other financial institutions. For example, individuals and businesses use banks to make payments to each other. So if you work in the cash man- agement department of a large bank, you may help companies electronically transfer huge sums of money as wages, taxes, and payments to suppliers. Banks also buy and sell foreign exchange, so you could find yourself working in front of one of those computer screens in a foreign exchange dealing room. Another glamorous bank job is in the de- rivatives group, which helps companies to manage their risk by buying and selling op- tions, futures, and so on. This is where the mathematicians and the computer buffs thrive. Investment banks, such as Merrill Lynch or Goldman Sachs, help companies sell their securities to investors. They also have large corporate finance departments which assist firms in major reorganizations such as takeovers. When firms issue securities or try to take over another firm, frequently a lot of money is at stake and the firms may need to move fast. Thus, working for an investment bank can be a high-pressure activ- ity with long hours. It can also be very well paid. The distinction between commercial banks and investment banks is narrowing. For ex- ample, commercial banks may also be involved in new issues of securities, while invest- ment banks are major traders in options and futures. Investment banks and commercial banks may even be owned by the same company; for example, Salomon Smith Barney (an investment bank) and Citibank (a commercial bank) are both owned by Citigroup.  FINANCE IN ACTION Working in Finance Susan Webb, Research Analyst, builders, operators, suppliers, and so on, were all in Mutual Fund Group place before we could arrange bank finance for the project. After majoring in biochemistry, I joined the research de- partment of a large mutual fund group. Because of my Albert Rodriguez, Emerging Markets Group, background, I was assigned to work with the senior Major New York Bank pharmaceuticals analyst. I start the day by reading the Wall Street Journal and reviewing the analyses that I joined the bank after majoring in finance. I spent the come in each day from stockbroking firms. Sometimes first 6 months in the bank’s training program, rotating we need to revise our earnings forecasts and meet with between departments. I was assigned to the Latin the portfolio managers to discuss possible trades. The America team just before the 1998 Brazilian crisis when remainder of my day is spent mainly in analyzing com- interest rates jumped to nearly 50 percent and the cur- panies and developing forecasts of revenues and earn- rency fell by 40 percent. There was a lot of activity, with ings. I meet frequently with pharmaceutical analysts in everyone trying to figure out what was likely to happen stockbroking firms and we regularly visit company next and how it would affect our business. My job is management. In the evenings I study for the Chartered largely concerned with analyzing economies and as- Financial Analyst exam. Since I did not study finance at sessing the prospects for bank business. There are college, this is quite challenging. I hope eventually to plenty of opportunities to work abroad and I hope to move from a research role to become a portfolio man- spend some time in one of our Latin American offices, ager. such as Argentina or Brazil. Richard Gradley, Project Finance, Emma Kuletsky, Customer Service Representative, Large Energy Company Regional Bank After leaving college, I joined the finance department of My job is to help look after customers in a large branch. a large energy company. I spent my first year helping to They seem to expect me to know about everything. I analyze capital investment proposals. I then moved to help them with financial planning and with their applica- the project finance group, which is responsible for ana- tions for loans. In a typical day, I may have to interview lyzing independent power projects around the world. a new customer who wants to open a new account with Recently, I have been involved in a proposal to set up a the bank and calm an old one who thinks she has been company that would build and operate a large new overcharged for a wire transfer. I like dealing with peo- electricity plant in southeast Asia. We built a spread- ple, and one day I hope to be manager of a branch like sheet model of the project to make sure that it was vi- this one. able and we had to check that the contracts with the The insurance industry is another large employer. Much of the insurance industry is involved in designing and selling insurance policies on people’s lives and property, but businesses are also major customers. So if you work for an insurance company or a large insurance broker, you could find yourself arranging insurance on a Boeing 767 in the United States or an oil rig in Kazakhstan. A mutual fund collects money from individuals and invests in a portfolio of stocks or bonds. A financial analyst in a mutual fund analyzes the prospects for the securities and works with the investment manager to decide which should be bought and sold. Many other financial institutions also contain investment management departments. For example, you might work as a financial analyst in the investment department of an in- surance company and help to invest the premiums. Or you could be a financial analyst in the trust department of a bank which manages money for retirement funds, universi- ties, and charitable bodies. 16  The Firm and the Financial Manager 17 TABLE 1.2 Representative salaries for Career Annual Salary senior jobs in finance Banking President, medium-size bank $225,000 Vice president, foreign exchange trading 150,000 Controller 160,000 Corporate finance Assistant treasurer 110,000 Corporate controller 165,000 Chief financial officer 250,000 Investment banking Institutional brokers 200,000 Vice president, institutional sales 190,000 + bonus Managing director 400,000 + Department head 750,000 + Money management Portfolio manager 136,000 Department head 200,000 Insurance Chief investment officer 191,000 + bonus Chief financial officer 168,000 + bonus Sources: http://careers.wsj.com; http://www.cob.ohio-state.edu/~fin/osujobs.htm (April 1999). Stockbroking firms and bond dealers help investment management companies and private individuals to invest in securities. They employ sales staff and dealers who make the trades. They also employ financial analysts to analyze the securities and help cus- tomers to decide which to buy or sell. Many stockbroking firms are owned by invest- ment banks, such as Merrill Lynch. Investment banks and stockbroking firms are largely headquartered in New York, as are many of the large commercial banks. Insurance companies and investment man- agement companies tend to be more scattered. For example, some of the largest insur- ance companies are headquartered in Hartford, Connecticut, and many investment man- agement companies are located in Boston. Of course, many financial institutions have large businesses outside the United States. Finance is a global business. So you may spend some time working in a branch overseas or making the occasional trip to one of the other major financial centers, such as London, Tokyo, Hong Kong, or Singapore. Finance professionals tend to be well paid. Starting salaries for new graduates are in the region of $30,000, rather more in a major New York investment bank and somewhat less in a small regional bank. But let us look ahead a little: Table 1.2 gives you an idea of the compensation that you can look forward to when you become a senior financial manager. Table 1.3 directs you to some Internet sites that provide useful information about careers in finance. Goals of the Corporation SHAREHOLDERS WANT MANAGERS TO MAXIMIZE MARKET VALUE For small firms, shareholders and management may be one and the same. But for large companies, separation of ownership and management is a practical necessity. For ex- 18 SECTION ONE TABLE 1.3 Internet sites for careers in Site URL Comment finance Wageweb www.wageweb.com Basic salary data. Wall Street Journal careers.wsj.com Extensive salary information, general advice, and industry prospects. Bureau of Labor Statistics www.bls.gov Government site with job and qualification profiles, as well as salary data. Go to “Publications and Research Papers” and then “Occupational Handbook.” Wetfeet www.wetfeet.com A site for beginning job seekers, with job tips and profiles of people and jobs in the industry, as well as information about industries and specific firms. Ohio State University www.cob.ohio-state. Extensive site with job descriptions, edu/~fin/osujobs.htm salary data, suggestions for further reading, and many Web links. ample, AT&T has over 2 million shareholders. There is no way that these shareholders can be actively involved in management; it would be like trying to run New York City by town meetings. Authority has to be delegated. How can shareholders decide how to delegate decision making when they all have different tastes, wealth, time horizons, and personal opportunities? Delegation can work only if the shareholders have a common objective. Fortunately there is a natural finan- cial objective on which almost all shareholders can agree. This is to maximize the cur- rent value of their investment. A smart and effective financial manager makes decisions which increase the current value of the company’s shares and the wealth of its stockholders. That increased wealth can then be put to whatever purposes the shareholders want. They can give their money to charity or spend it in glitzy night clubs; they can save it or spend it now. Whatever their personal tastes or objectives, they can all do more when their shares are worth more. Sometimes you hear managers speak as if the corporation has other goals. For ex- ample, they may say that their job is to “maximize profits.” That sounds reasonable. After all, don’t shareholders want their company to be profitable? But taken literally, profit maximization is not a well-defined corporate objective. Here are three reasons: 1. “Maximizing profits” leaves open the question of “which year’s profits?” The com- pany may be able to increase current profits by cutting back on maintenance or staff training, but shareholders may not welcome this if prof