Part One vee ‘To canyon busines, a cororation needs an slanost ends varity of real asets. These assets donot drop re fom a lu hy they need to be paid fo. Ta py for el sets the oxporation sls claims onthe asets and on the esh ow et they wll generat. These slams are called Baameal asses or securities. Take ban loan stan exaple.The bank Provides the corporation wath esh in exchange for 3 nancial se, which the compo tion's promise to repay the loan with interes. An ordinary bank oun is ot sect, however, because its held by the bank and not sold or ade in inna markets, Take a corporate bond second example, The corporation sl the bond fo investors i exchange forthe promise o pa intrest on the bond and o payoff the bond ait mtu fy. The Bond isa financial ast and also a secu, because can be held by and traded mong many investor in financial market. Secures ince bonds, shares of stock nd 2 dizyingvasety of specialized instrament, We describe bonds in Chapter 3, teks in (Chapter and ther teuries i ater chap “This suggests the Following definitions Invesument decision = purchase of real sets Financing decision = sale of financial sets ‘But these equations are too simple. The investment decison aho involves managing asses already in place and deciding when to shot down and dpe of ast if pots ‘elie. The cooration also has to manage and conta the rsks of ts investments. The financing decision includes not jum rang cash today but also micting obligations to bank, bondholder, and stockholders that contabuted financing in the past. For example, the corporation hast epay ts debs when they Become de Ii cannot dos, end sp insolvent and bankrup. Sooner or later the corporation wll ao want to pay Out ash £0 iteshaeholdr [Let's goto morespecific examples. Table 1. it nine compoatons. Four are US orpo- tations. Fv ae foreign: GlaxoSmithKlne's headquarters ate in Landon, LVM’ Para? Shells in The Hague, Toyous in Nagoya, and Lenovo's in Bing, We have chon very lage public coxporations that you ae probably already Filia wth. You probably have ‘evel on a Boeing et, shopped at Wal Mart, or used a Wells Fargo ATM, for example Investment Decisions The second column of Table. shows an impostant seen investment dein foreach corporation. These investment derision ar fen fered toa npital budgeting 0” cap {al expenditure (CAPEX) decisions, because mot lage comporations prepare an anal pita budget iting the maior projects approved for investment Some of the investments ln Table 1.1, such as Wal Mars new stores or Union Pacifi's new locomotives, invalve the purchase of tangible assts=asets that you an touch and kik. Corporations abo need {o inves in intangible assets, however. These include retearch and development (R&D), lvertsing and meting. For ample, GlaoSmithRline snd other mor pharmacee ‘ical companies inves bilions every Year an RAD for new drugs. These companies ao Invest to market thee exising produc saint Capt aad wal ona a BeeChapter 1 oaks st Gaverane af he Fm errr forza} ees ees eon 1 Bon Skgapsitont se Omamiar Tesh tow to ong prates Seis tetscatmon ton oma toy sone ie Sohn owen 28 ona ok Aopen Se 8 is) anced aS lender TOR snd 181 Bon (arian cote ‘eissosnle bj ake 8280 tn) In2oh pore prurg sty are Yano seeder eusmeine(24on) SLES Maen 208 en eens te France ALD acento hogan no dae fees how prey et Sorementeaponce ra 0809 Inco anode meters cee $25 enya ‘onstrates na yar an Ser one or ace san Aci en omen 207. ag tae nn a scoot eno mes ets ion) cures osetia 208 rane ten by mE Sis ten oie ae ty Acq Ssh wen Soph saa sy an 207, eg Sine mes ‘soimion Sess Lenoir Lape sal tte cme braun 0 lone a re 2t00 ce orate D TABLE 1.1. camps ese tne ss amin Soon alr pe capes Today's capital investments generate ature returns, Often the retums come inthe di ‘ant ature, Boeing commited over $10 billion to desig, est, and manufacture the Dream liner I id so Beaune st expects thatthe plane wil generate cash returns fr 30 yest or more fer it fir enter comercl sevice. Thote ith returns mst recover Boeings huge nial investment and provide a least an adequate rot on tat invesment, The longer Boring must wat for Cash to flow back, the gester the prot that i requires. Tha the financial manager mus pay attention to the sming of projet reruns, not jus thei cual tiveamoun In edition abese etm are razly enti Ane projec could be a smashing sees ora dismal aut, ‘Ofeoune ot cvery investment has such distant pays as Boing’ Dremline, Some investments have only shore consequences. For eampl, withthe approsch ofthe CCuismss holiday, WalMart spends about $40 billion ta tock up its warehouses snd retail sores. As the goods at sold ove the falling month, the company recover this "nancial manages do not make major investment decisions in solitary confinement ‘They may works part of 3 txm of engineers and manager from manufituring, ake ing and other business fonctions. Also, do ot think of the financial managers making, bilion-dllsr investments on 2 daily basis Most investment dione ae smaller nd i= let, sack a the purchase of a tick, machine toa, or computer system. Corporations ‘make thoutands of thee smaller investment decisions every yer The cumulative smount of smal investments an be ust as lige as dhat of the oceasinal big investments, sch 3 ‘hove shown in TablePart One vue Financing Decisions “Te hid column of Table 1. lis a een inancng decison by each corporation. A corpo- tion can ase mone (sh) or lenders or Fm sharholr ft boo, the lender on tnbute he ethan the corporation promises wo pay back be deb pla ed at fine Ifthe sharholders pt up the cash, they ge no ae er, bu they hold sates of tock nd therfoe ge a faction of fare profits and cath low. The sharchollen eu mst who contribute ew fang The choice between debt and equity financing led the ‘capital souetue decson.Ciptal efer to the fis sarc of lange nancing "he financing choices avalable wo lrge corporations sem almot endless Suppot the fim decides wo borrow. Shou it borrow from a bank orborow by hein bonds that can De traded by investors? Should it haow for I year a 20 year? Iie borrows for 20 yea, should it reserve the ight py of the deb aly ners rates fl? Shout Bortom in Pans, ceiving and promising to repay euros o should borow dolls in New York? AAs Table 1] shows, he reach company LVMH borrowed Swi franc, but cou have bowed dolla o eros ntesd (Corporations raise equity Haancing ia two ways. Fint, they can tse new shares of stock The investors who buy the new shares put up eash in exchange for a Faction ofthe ‘orporaon’s future cashflow and pros Second, the corporation ean take the cash Now {generated by its existing ast and reinvest the cath in new st In this cathe corpore tion is einvesting on Behalf of existing ocho. No new share ae ied. ‘What happens when 3 corporation doesnt inves ll ofthe cath low generate by its ‘xistng asses? Iemay had dhe cash in reserve Fr ftre investment ort may pay the cash back to ts shareholders. Table 1 shows chat in 2008 Toyota pid cash dividends of ¥A31 bilion, equivalent to about S43 billion. In the same yet Shel pid back $1341 billion to its stockholders by repurchasng shares, This was in aaa o $9 Silion pai out a cash dividends. The decision to pay dividends or repurchae share is cle the pao das ‘We cover payout decisions in Chap 16. Tn some ways fsancng desons are less imporant than investment decisions Finan cial managers say that “Ylue comes mainly fom the ast side ofthe balance she.” In fact the most success corporations sometimes have the simplest financing stati. Take Microsoft as an example [eis ne of the world’s most valuable corporations. tthe cd of 2003, Microsoft shares waded for $19.44 each, There were about 89 blon shares fustanding Therefore Microsofts overall markt values markt eaptalzaton or marke! ‘ap=was $19.44» 89 = $173 billion, Where dd tht market value come from? I came fom Microsofs product development, fom its brand name and worldwide curtomer bse, fom is sescurch and development, and fom its ability ro make profitable futte invessmens. The vlue did mi come fom sophisticated financing, Micros Snancing stategy is wery spe: it caties no debt eo speak ofan finances alos al investment by ‘etinng and cinwestng cath om: Financing decions may not add snuch valu, compared with good investment deci sons, bur they ean destroy vale if they ae stupid ori they ate ubushed by bad news, Forexample, when real eta mogul Sam Zales buyout ofthe Chica Tien 2007, the newspaper ook on about 88 blon of addional debt. This was nota stupid decision, bit id prove al As advenising revenes Fel away in the reersion of 2008, the Tribe could no longer servic its debt. Ip December 2008 filed for bankeupty with aes of ‘S7silion and debts of $129 billion Busines is inherent sky. The nancial manager needs to iensif the sks and make sure they ae managed propery For example, debt hat advantages, bo oo mich debt ‘inland the company in banrupty, as the Chiao Tune discovered. Cnmpanies can tbo be noche af course by eecestons, by changer in commodity pie, interes aes and ‘exchange ates orb adverse political developments. Some of thes iss can be hedged or insured, however, as we explain in Chapter 26 and 27,Chapter Gels ane Govenanc ote Fm What Is a Corporation? ‘We have ben refering to “corporations” Before going too fr orto it, we offer some bse definitions. Det follow a needed in ater chapter ‘A corporation is ya entity Inthe view of th aw iti legal por that ie owned by itsshareholders As legal person, the corporation can make conta cary om 2 busines, borrow or lend money and sue or be sual. One corporation can make takeover bid fo nother and then merge the oo busineses Corporations pay tae+-bet cannot ve! Inthe US, corporations ae formed under state law, bas on ati of arertion that stout the purpose ofthe business and how it so be governed and operated” For trample, the articles of incorporation specify the composition and role of the Bard of Actr A corporation's decors choose and advise top management and ae reqhred to sgn off on Some corporate actions, sch a merges snd the payment of dividends to Shaseholden. ‘A corporation is owned by it shareholders but i legally distin fom them. Therefore the shareholders have limited Wabi, which means hat shareholders cannot be Held personally responsible forthe compotion debts. When the US. financial corporation chman Brothers fled in 2008, no one demanded tha st stockholder put up More ‘money to cover Lehman's manive debt. Shareholders an ote ther ene investnent in 2 corporation, but no more. ‘Corporations donot have tobe prominent, mulation businesses like thos listed in ‘Table. You can ofganie a loa plumbing contactor or barbershop at a oxporaton if you want ro ake the trouble But usally corporations re lager businewes or busines thataspire wo gow. "When 2 corporation is fist established its shes may be prvately held by a small group of investors, pesaps the company’s managers and afew backers In this cae the sates ae ‘ot public waded andthe company i do bel. Evenusly, when the fim goms and ‘ew shares are sued wo eaise atonal capital, it share sre taded in public mare such 2 the New York Stock Exchange. Such corporations ae known 3 pi cmpomer Most ‘elhinown coocations in the US. ae pub companies with widely dispersed shareholé- ing. In other countries, its more common for lrg corporation t remain in private hands, and many publ companies may be controlled by ust handil of investor, The Tater category includes such ell Anowa names as Fat, Poche, Benetton, Bosch, IKEA, and the Swatch Group, ‘A larg pubic corporation may ave hundreds of thousands of shareholder, who own the busines but cantot possibly manage or conte it diet. This npaaton of ump ‘and cone sves corporations permanence. Even if manages quit or ae dismised and ‘replaced, the corporation survive. Today’ stockholders can all dee shtes to ne investors withoot duping the operations ofthe business. Corporations ean in principe, live forever, and in practice they may sorve many human ities. One ofthe odes ‘corporations isthe Hudson's Bay Company, which ws formed in 1620 o profit fom the fur vade betveen norther Canada and England. The company sil operates ss one of ‘Canad’ leading rei chans “The spstation of emnehip and control can also have a downside, frit can ope the oor for manager and dirctors oat nti own intrest ater than in he socks Imerest We eur to this problem tern the chapter ASUS cps ml inc cp! et ia Cp eT Ux oman percent pe tonto See nnd pom fos ao tence ae ‘Shonen Coma aa ec mt ns Hao A ‘Sg ig be te or ala ed per Sel inn sb cei emt ep cr Hae en a bs as—s PartOne vue PT ‘What do Binncial manager do for a lving? That simple quetin can be answered in several mays We cn tat with financial manager job ites. Mos large corporations have 8 chief financial officer (CFO), who oversees the work of ll finance sta. The CFO ie Aeepy involved in financial poy and financial planning andi im constant conti with the Chie Executive Ofer (CEO) and other top management. The CFO the most inmporant financial voice ofthe corporation, st explain earings sats and forecast to investor and the medi. ‘Below che CEO are usually a treasurer an 3 controle. The reser i responsibe for Sorter eah management, currency trading. financing transactions, and bank elation Ships. The conuoller manages the company’s ftemalSecounting stems and oversees Preparation ofits financial sttements and tr retums. Te larger corporations have dozen Df mote specialized Rinancal manage inching tax lawyers and accountants, expert in panning and forecasting, and managers responsible for investing the money set aside for Employee reurement plans Financial decisions ar ot rested to Gnancial pein. Top management mst sign offon major investment projets, Fr example, Butte engineer who designs x new prod tiom ine ils invaved because the desig determines the ral sets tha the corporation holds The engineer lo rece many designs before proposing what he or she thinks isthe best one. Those eetons se als investment decison, becase they amount to detons sat invest in other types of relat. Tn this book we we the term func! mang o reer to anyone responsible fora invesoment or financing devson. Ofen we ue the tem cole forall the manages drawn int sch decions, e's go beyond jo tiles. What is the esental role ofthe financial manage? Fgue tives one anster. The igure aces how money lows rom investors othe corporation td fret investors again. The flow star then ca sized rom investors (aow Lia the figure). The each could come fom banks of from Secu sold to invertor in Gna smashes. The cash i then Wied to pay for the real set (invement project) eee for the conporation’s busines (row 2) Late, asthe busines operates, the anes generat cash Inflow 3). That eth isether ested (arom 4) oretumed othe vests ho fanished the money inthe is place (atow 40). OF couse, the choice between arom 4 ad 4 constained bythe promises made when cath wat ave at arow I. For example Ifthe fren Bortons money fom a bank at atom 1 must epy this money pl mcs atattow fk eee tesco, — ‘sling fingneial assets 1 investors; (2) cash —— —_— a . Sicmecmensg Sa mueereacco, tg = fan's open het) heeinad oerChapter Gass ar Gonna fe Fem — You can se examples of arows fe and 4b in Table 1.1. GlauoSmitklne financed its rag research and devlopment by ceinvestng earings arow 4a) Shell decided to etm ‘ash to shareoldes by Buying bick is tock (atow 40. Sell could have chosen instead to py the money outa additonal eth dividends [Notice how the nail manager and between the in and outside investors On the ‘one hands the financial manager helps manage the Fs operation, patil by help ing t9 make good investment decisions. On the other hand he financial manager deals with investorsnot just with shareholders but slo with fnanclineitions such banks 2nd with Enancil mares soc athe New York Stock Exchange, ‘The Investment Trade-off Now look at Figute 12, which ses ou the fundamental ade for corporate investment {decisions The corporation has a proposed intestmen projet (rea a). Suppose thas ‘ash on hand suficent to nance the projet. The financial manage ying to decide ‘whether to invest in the projec the financial manager decides not to inset, the compre: tion can pay out the esto shareholders, say at an extra dividend, (The investinent and Aivdend mows in igure 12 ae atows 2 snd 4b in Figur 1.1.) “Assume tha the Rancial manager ie acing inthe interest ofthe conporton’s ner, its stockholders, What do these toekoldes want the Financial manage todo? The answer depends on the ate of retum on the investment projec and onthe ate of rerum that the stockholders an ear by investing in financial mares Ihe return offered by the ines ‘ment project is higher than he ate of er that hacholdrs can ge by iavesing on thet ‘own, then the shareholders would ate fo the iveament pret the investment roe ‘offers lower eeu than sharholders can achcre on thet own, the shareholder would ‘ote to cancel the project and ake the eas instead igure 12 could apply to Wal Marts decisions to invest in new stil tors, for example Suppose WalMart ha ash seaside wo build 10 new sores in 20121 coud go head with the new stores, or it could choose co cancel the investment project and instead pay the ‘ash out eis stokes. Ft pay ov the cath the octhoer ould thet ives for therseres, ‘Suppose that Wal-Man’'s newstores projec ijt abot a sky 3th U.S, stock mae ter and tha investment in the tock maker offers 10 expected rae of seta, I the ‘ew stores offer a superior ate ofretum, sy 20%, then Wal-Mar's stockholders would be bation) Hise rence seoetaers > rune 1.2 Are can Bae wean ash frre ie tie rows eat posse ca ons ‘rests Heaths isto opt yeast th pect ‘amr ra a ‘Sorrel a ‘aes yagi ‘ncPart One ve happy to let Wal-Mar keep the cash and invest itn the new sore Ithe new soe offer only 239 rerun then the stockholders te beter of with the cash and without the new Sores in dat ae the Financial manager shoul turn down the investment projet ‘As long aba corporation's proposed investment offer hight rates of rer than its Sharcholden ean eam for themselves in the sock make (or inher financial ase), Shareholds wil applaud the invertment and ite tock pice wil inctesse. But fhe com pany ears an inferior return shacholde boo, stock price fll nd wockholders demand their money bac so the they can invest on their wn, In our example the minimum acceptable rate of return on Wal Mats new stores i 10%, This minimum rate of recur sealed a Bde rate orcs of pital Ie is relly an ‘opportunity cost of capt because ie depends onthe investment eppirtunts avaiable to imestors in financial matkes. Whenevet a corporation inverts cath in nem PIO: ‘ect is shareholders lose the opportunity to invert the cash on thei own. Coxporations inciease value by aceptng all investment projects that car more than the opportnity tof capital [Notice that he opportunity cost of capital depends onthe sk ofthe proposed inves ment projet Why? fs no jut because sharchoiers are ik avert ao beats shar holders have o cade off sk against reara when they invest on thei own. The salet investments, suchas US. goverment deb, offer low fates of rem. Zavestnents with higher expected rates of retumthe stack market, for examplemae sit and srntiet deve pinfl loses. (The US. stock marker was down 386 in 2008, for example) Other inveserents ae sser sill For example, hightech gromth stocks oer the prospect higher rates of eur, but are even mote vlate "Notice wo thatthe opportunity cot of capital x generally athe interstate that he company pays on loan om a banka on 3 Band. Ifthe company maknga ek inves tment the opportunity cos is the expeced ret that investors ca achive in nani markets tthe same level of risk The expected rerun om ky secures ir normaly well hove the interes rate om corporate borowing ‘Managers oat the nancial markets to mesure the opportunity cost of capital forthe fi’ invesinent projects. They en bere the oppornity cos oF capital forse ve ‘ments by looking up current intrest ats on sae deb secs. Fo ky invextment, the ‘opportunity cost of capital hs tobe etimated. We wart tackle thi tank in Chapter 7. Eximating the opportunity cost of expt sane othe hardest tks in inant man agement, even when the stock, bond, nd ether financial markets ate Behaving normal, ‘When these markets re misbehaving. pecs estimates ofthe eos ofepital can be tempo rail out of the quesson Financial markets inthe U.S. and most developed counties wok well most of he time bbutjat like heli gin he poem, "When they are god, they are vey good indeed but ashen they ae bad they are homnd-” in 2008 financial masts were hort Security pies [bounced sfound like Tigger on simulans and for some types of investment the market temporarily disappeared: Financial markets no longer flere 3 good yardstick fo 3 pro ‘e's value othe opportunity cos af expt Tht ws 3 year in which financial manages teal ered thei keep. ‘We give more specific examples of investment deckons and the opportunity cost of capital athe sar ofthe nex chapter nse ml her