Essentials of Managerial Finance PDF
Preview Essentials of Managerial Finance
Licensed to: Licensed to: Essentials of Managerial Finance, Fourteenth Edition Scott Besley and Eugene F. Brigham VP/Editorial Director: Sr.Technology ProjectManager: Art Director: Jack W.Calhoun Matt McKinney Bethany Casey Publisher: Marketing Manager: Cover and Internal Designer: Alexvon Rosenberg Jason Krall Red Hanger Design,LLC Executive Editor: Sr.Marketing Cover Images: MikeReynolds Communications Manager: Veer Incorporated/Artist: Jim Overly Neil Brennan Sr. DevelopmentalEditor: Elizabeth Thomson Sr.Manufacturing Coordinator: Compositor: Sandee Milewski International Typesetting Editorial Assistant: and Composition Adele Scholtz Printer: RR Donnelley Project Management: Content ProjectManager: Willard Manufacturing Division Graphic World,Inc. Elycia Arendt Willard,OH Manager ofTechnology, Editorial: John Barans COPYRIGHT #2008,2005 ALL RIGHTSRESERVED. Nopart Library ofCongress Control Number: Thomson South-Western, apart of ofthiswork covered bythecopyright 2007925965 TheThomson Corporation. Thomson, hereon may bereproducedorusedin the Star logo,and South-Western are any formorbyany means—graphic, trademarks usedherein underlicense. electronic, ormechanical, including For moreinformation aboutour photocopying, recording, taping,Web products, contactus at PrintedintheUnitedStatesofAmerica distribution orinformation storage Thomson Learning Academic 1 2 3 4 5 10 09 08 07 and retrievalsystems, orinany other ResourceCenter manner—withoutthe written permis- ISBN13:978-0-324-42270-2(package) sion ofthepublisher. 1-800-423-0563 ISBN 10:0-324-42270-9(package) ISBN 13:978-0-324-65216-1(book) Forpermissiontousematerialfromthis ISBN 10:0-324-65216-X(book) textorproduct,submitarequestonline ThomsonHigher Education athttp://www.thomsonrights.com. 5191Natorp Boulevard Mason, OH45040 USA Copyright 2008 Thomson Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Licensed to: CHAPTER 1 An Overview of Managerial Finance A M P ANAGERIAL ERSPECTIVE W hen you invest in the common stock of a who are interested only in increasing their own wealth company, what do you hope (expect) to positions.Consider,forexample,thattheCEOofPfizer gain?Rationalinvestorswouldanswerthis waspaid$79millionduringtheperiod2001(cid:1)2005and question with a single word—wealth. As you will dis- theCEOsofHomeDepotandVerizonCommunications cover in this chapter, a corporation acts in the best werepaid$27millionand$50million,respectively,during interests of its stockholders when decisions are made the period from 2004(cid:1)2005, even though at the same thatincreasethevalueofthefirm,whichtranslatesinto time these same firms produced negative returns for an increase in the value ofthe company’sstock. stockholders.1 According to Paul Hodgson, senior The managers of large corporations generally are research associate at The Corporate Library, this is evi- encouraged to ‘‘act in the best interests’’ of the firms’ dence‘‘thatthelinkbetweenlong-termvaluegrowthand stockholders through executive compensation packages long-termincentive awardsisbroken attoomanycom- thatreward‘‘appropriatebehavior’’—thatis,actionsthat panies—ifitwaseverforgedproperlyinthefirstplace.’’2 increasefirms’values.Whenmanagersactintheirownbest In recent years, investors have said, ‘‘Enough is interestsandstockholdersbelievethatvalueisnotbeing enough.’’ Stockholders are now demanding, and more maximized, these executivesoften are ousted from their boards of directors are imposing, tougher rules with verylucrativepositions.Soundslikeagoodplan,doesn’tit? regardtocompensationpackages,makingitmorediffi- Althoughitseemslikeagoodideatorewardmanagers cultforexecutivestoearnexcessivesalaries.In2006,for whorunfirmswiththebestinterestsofthestockholders example,theshareholdersofPfizer,MerrillLynch,Mor- (owners) in mind, in recent years stockholders have ganStanley, GeneralElectric, Citigroup, andRaytheon, complainedthat executive compensation plansin many among others, became much more active in expressing largecorporationsprovideexcessiverewardstoexecutives their feelings about ‘‘excessive’’ executive pay plans.3 1AlanMurray,‘‘CEOsoftheWorld,Unite?WhenExecutivePayCanBeTrulyExcessive,’’TheWallStreetJournal,April26,2006,A2. 2‘‘PayforFailure,’’TheCorporateLibrary,http://thecorporatelibrary.blogspot.com/.TheCorporateLibraryprovidesarticlesandinformationabout corporategovernanceandexecutivecompensation.AdditionalreportsaboutCEOcompensationcanbefoundbysearchinghttp://money.cnn.com/using thekeywords‘‘CEOpay.’’ 3‘‘GettingActive,’’TheWallStreetJournalOnline,May4,2006. 3 Copyright 2008 Thomson Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. 4 Chapter 1 An Overview ofManagerialFinance A compensation plan that has received a great deal of excessiveseverancepay.Moreboardsofdirectorsare Licensed to: attention recently is the policy of offering ‘‘golden redefiningwhatitmeanstobefiredfor‘‘justcause’’to parachute’’ packages that provide executives with include a wider range of actions or nonactions for excessivepaymentswhentheyaredismissedfromtheir whichexecutivescanbedismissedwithoutseverance firms. In the past, a golden parachute, which gets its pay. Firms now are including poor firm performance name from the fact that a significant severance pay asa justifiable reason for dismissing executiveswith- permits an executive to easily ‘‘land on his or her out severance. It seems that stockholders are financial feet’’ after dismissal from the company, ‘‘speaking their minds,’’ and the boards of directors often had to be honored no matter the reason for of many companies are listening.4 dismissal;oneexceptionwouldbeifacriminaloffense As you read this chapter, think about the issues wascommittedbytheexecutive.Morecompaniesare raisedhere:Asastockholderinacompany,whatgoal(s) now limiting the amount of the severance pay that wouldyouliketosee pursued? Towhat extent should executives can earn. In addition, large corporations, topmanagerslettheirownpersonalgoalsinfluencethe including ImClone Systems, NCR Corporation, and decisions they make concerning how the firm is run? Walt Disney Company, are revising their policies so Whatfactorsshouldmanagementconsiderwhentrying thatitiseasiertofireexecutiveswithouthavingtopay to‘‘boost’’thevalueofthefirm’sstock? Afterreading thischapter, you shouldbeable to answer thefollowing questions: Chapter Essentials (cid:2) What is finance, and why should everyone understand basic financial concepts? —The Questions (cid:2) What are the different forms of business organization? What are the advantages and disadvantages of each? (cid:2) What goal(s) should firms pursue? Do firms always pursue appropriate goals? (cid:2) What is the role of ethics in successful businesses? (cid:2) How do foreign firms differ from U.S. firms? ‘‘Why should I study finance?’’ You probably are asking yourself this question right now.Toanswerthisquestion,weneedtoansweranotherquestion:Whatisfinance? W I F ? HAT S INANCE In simple terms, finance is concerned with decisions about money, or more appro- priately, cash flows. Finance decisions deal with how money is raised and used by businesses, governments, and individuals. To make rational financial decisions, you must understand three general, yet reasonable, concepts: Everything else equal, (1)morevalueispreferredtoless;(2)thesoonercashisreceived,themorevaluableit is;and (3) less risky assets are more valuable than (preferred to)riskier assets. Inthisbook,wewillshowthatafirmthatpracticessoundfinancialmanagement canprovidebetterproductstoitscustomersatlowerprices,payhighersalariestoits employees,andstillprovidegreaterreturnstoinvestorswhoputupthefundsneeded toformandoperatethebusiness. Becausetheeconomy—both national andworld- wide—consistsofcustomers,employees,andinvestors,soundfinancialmanagement contributes tothe well-beingof both individualsandthegeneralpopulation. Althoughtheemphasisinthisbookisbusinessfinance,youwilldiscoverthatthe sameconceptsthatfirmsapplywhenmakingsoundbusinessdecisionscanbeusedto make informed decisions relating to personal finances. For example, consider the decisionyoumighthavetomakeifyouwonastatelotteryworth$105million.Which 4JoannLublin,‘‘JustCause:SomeFirmsCutGoldenParachute,’’TheWallStreetJournal,March13,2006,B3,and ‘‘GettingActive,’’TheWallStreetJournalOnline,May4,2006. Copyright 2008 Thomson Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. General AreasofFinance 5 would you choose, a lump-sum payment of $54 million today or a payment of $3.5 Licensed to: millioneachyearforthenext30years?Whichshouldyouchoose?InChapter4wewill showthattimevalueofmoneytechniquesthatfirmsusetomakebusinessdecisionscan beusedtoanswerthisandotherquestionsthatrelatetopersonalfinances.Infact,in eachchapter,wewillshowhowthegeneralbusinessfinanceconceptsthatarepresented applytodecisionsaboutpersonalfinancialmanagement. What are somecommon personal finance decisionsthat individualsface? G A F ENERAL REAS OF INANCE The study of finance consists of four interrelated areas: (1) financial markets and institutions, (2) investments, (3) financial services, and (4) managerial finance. Although our concern in this book is primarily with managerial finance, because thesefourareasareinterrelated,anindividualwhoworksinanyoneareashouldhavea good understanding ofthe other areasas well. Financial Markets and Institutions Financialinstitutions,whichincludebanks,insurancecompanies,savingsandloans, andcreditunions,areanintegralpartofthegeneralfinancialservicesmarketplace. The success of these organizations requires an understanding of factors that cause interest rates to rise and fall, regulations to which financial institutions are subject, and the various types of financial instruments, such as mortgages, auto loans, and certificates of deposit, thatfinancial institutions offer. Investments Thisareaoffinancefocusesonthedecisionsmadebybusinessesandindividualsas they choose securities for their investment portfolios. The major functions in the investments area are (1) determining the values, risks, and returns associated with such financial assets as stocks and bonds and (2) determining the optimal mix of securities that should be held in a portfolio of investments. Financial Services Financial services refers to functions provided by organizations that operate in the finance industry. In general, financial services organizations deal with the manage- ment of money. People who work in these organizations, which include banks, insurancecompanies,brokeragefirms,andothersimilarcompanies,provideservices thathelpindividuals(andcompanies)determinehowtoinvestmoneytoachievesuch goalsashomepurchase,retirement,financialstabilityandsustainability,budgeting, andrelatedactivities.Thefinancialservicesindustryisoneofthelargestintheworld. Managerial (Business) Finance Managerial finance deals with decisions that all firms make concerning their cash flows. As a consequence, managerial finance is important in all types of businesses, whether they are public or private, deal with financial services, or manufacture products.Thetypesofdutiesencounteredinmanagerialfinancerangefrommaking decisionsaboutplantexpansionstochoosingwhattypesofsecuritiestoissuetofinance Copyright 2008 Thomson Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. 6 Chapter 1 An Overview ofManagerialFinance such expansions. Financial managers also have the responsibility for deciding the Licensed to: credit terms under which customers can buy, how much inventory the firm should carry, how much cash to keep on hand, whether to acquire other firms (merger analysis), and how much of the firm’s earnings to reinvest in the business and how much to pay out asdividends. Ifyoupursueacareerinfinance,youwillneedsomeknowledgeofeachoftheareas offinance,regardlessofwhichareayoumightenter.Forexample,abankerlendingto abusinessmusthaveagoodunderstandingofmanagerialfinancetojudgehowwellthe borrowing company is operated. The same holds true for a securities analyst. Even stockbrokersmustunderstandgeneralfinancialprinciplesiftheyaretogiveintelligent advice to their customers. At the same time, corporate financial managers need to knowwhattheirbankersarethinkingaboutandhowinvestorsarelikelytojudgetheir corporations’performancesandthus determine their stock prices. What are the fourmajorareas offinance? T I F N A HE MPORTANCE OF INANCE IN ONFINANCE REAS Believeitornot,everyoneisexposedtofinanceconceptsalmosteveryday.Forexample, when youborrowtobuya car orhouse, finance concepts are usedtodetermine the monthlypaymentsyouarerequiredtomake.Whenyouretire,financeconceptsareused todeterminetheamountofthemonthlypaymentsyoureceivefromyourretirement plan.Ifyouwanttostartyourownbusiness,anunderstandingoffinanceconceptsis essentialforsurvival.Thus,evenifyoudonotintendtopursueacareerinafinance- relatedprofession,itisimportantthatyouhavesomebasicunderstandingoffinance concepts.Similarly,ifyoupursueacareerinfinance,itisimportantthatyouhavean understandingofotherareasinthebusiness,includingmarketing,accounting,produc- tion,andsoforth,tomakemoreinformedfinancialdecisions. Let’sconsiderhowfinancerelatestosomeofthenonfinanceareasinabusiness. Management Whenwethinkofmanagement,weoftenthinkofpersonneldecisionsandemployee relations,strategicplanning,andthegeneraloperationsofthefirm.Strategicplanning, whichisoneofthemostimportantactivitiesofmanagement,cannotbeaccomplished withoutconsideringhowsuchplansimpacttheoverallfinancialwell-beingofthefirm. Suchpersonneldecisionsassettingsalaries,hiringnewstaff,andpayingbonusesmust becoordinatedwithfinancialdecisionstoensurethatanyneededfundsareavailable. Forthesereasons,managersmusthaveatleastageneralunderstandingoffinancial management concepts tomake informeddecisions in their areas. Marketing Ifyouhavetakenabasicmarketingcourse,probablyoneofthefirstthingsyoulearned wasthatthefourPsofmarketing—product,price,place,andpromotion—determine thesuccessofproductsthataremanufacturedandsoldby companies.Clearly,the pricethatshouldbechargedforaproductandtheamountofadvertisingafirmcan affordfortheproductmustbedeterminedinconsultationwithfinancialmanagers becausethefirmwilllosemoneyifthepriceoftheproductistoolowortoomuchis spentonadvertising.Coordinationofthefinancefunctionandthemarketingfunction Copyright 2008 Thomson Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. The Importance ofFinance in Nonfinance Areas 7 is critical to the success of a company, especially for a small, newly formed firm, Licensed to: becauseitisnecessarytoensurethatsufficientcashisgeneratedtosurvive.Forthese reasons,peopleinmarketingmustunderstandhowmarketingdecisionsaffectandare affected by such issues as funds availability, inventory levels, and excess plant capacity. Accounting Inmanyfirms(especiallysmallones),itisdifficulttodistinguishbetweenthefinance functionandtheaccountingfunction.Often,accountantsmakefinancedecisions,and viceversa,becausethetwodisciplinesarecloselyrelated.Infact,youmightrecognize someofthematerialinthisbookfromaccountingcoursesthatyouhavealreadytaken. As you will discover, financial managers rely heavily on accounting information because making decisions about the future requires information about the past. As aconsequence,accountantsmustunderstandhowfinancialmanagersuseaccounting informationinplanninganddecisionmakingsothatitcanbeprovidedinanaccurate andtimelyfashion.Similarly,accountantsmustunderstandhowaccountingdataare viewed (used) by investors,creditors, and other outsiders who are interestedin the firm’s operations. Information Systems Businesses thrive by effectively collecting and using information, which must be reliableandavailablewhenneededformakingdecisions.Theprocessbywhichthe deliveryofsuchinformationisplanned,developed,andimplementediscostly,butso aretheproblemscausedbyalackofgoodinformation.Withoutappropriateinforma- tion, decisions relating to finance, management, marketing, and accounting could provedisastrous.Differenttypesofinformationrequiredifferentinformationsystems, so information system specialists work with financial managers to determine what informationisneeded,howitshouldbestored,howitshouldbedelivered,andhow information management will affectthe profitability of thefirm. Economics Financeandeconomicsaresosimilarthatsomeuniversitiesandcollegesoffercourses relatedtotheseareasinthesamedepartmentorfunctionalarea.Manytoolsusedto makefinancialdecisionsevolvedfromtheoriesormodelsdevelopedbyeconomists. Perhaps the most noticeable difference between finance and economics is that financial managers evaluate information and make decisions about cash flows asso- ciated with a particular firm or a small group of firms, whereas economists analyze informationandforecastchangesinactivitiesassociatedwithentireindustriesandthe economyasawhole.Itisimportantthatfinancialmanagersunderstandeconomicsand that economists understand finance—economic activity and policy impact financial decisions, and vice versa. Financewillbeapartofyourlifenomatterwhatcareeryouchoose.Therewillbea numberoftimesduringyourlife,bothinbusinessandinapersonalcapacity,whenyou will make finance-related decisions. It is therefore important that you have some understandingofgeneralfinanceconcepts.Therearefinancialimplicationsinvirtually all business decisions, and nonfinancial executives must know enough finance to incorporatetheseimplicationsintotheirownspecializedanalyses.Forthisreason,every studentofbusiness,regardlessofhisorhermajor,shouldbeconcernedwithfinance. Copyright 2008 Thomson Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. 8 Chapter 1 An Overview ofManagerialFinance Finance in the Organizational Structure of the Firm Licensed to: Althoughorganizationalstructuresvaryfromcompanytocompany,Figure1-1presentsa fairlytypicalpictureoftheroleoffinanceanditsrelationshipwithotherareaswithina firm.Thechieffinancialofficer(CFO),whooftenhasthetitleofvicepresidentoffinance, reportstothepresident.Thefinancialvicepresident’skeysubordinatesarethetreasurer andthecontroller.Inmostfirms,thetreasurerhasdirectresponsibilityformanagingthe firm’scashandmarketablesecurities,planninghowthefirmisfinancedandwhenfunds areraised,managingrisk,andoverseeingthecorporatepensionfund.Thetreasureralso supervises the credit manager, the inventory manager, and the director of capital budgeting,whoanalyzesdecisionsrelatedtoinvestmentsinfixedassets.Thecontroller isresponsiblefortheactivitiesoftheaccountingandtaxdepartments. Why dopeopleinareasoutsidefinancial management need toknowsome- thing about managerial finance? Identify the twosubordinateswho reporttothe firm’s chief financial officer and indicate the primaryresponsibilitiesofeach. A F B O LTERNATIVE ORMS OF USINESS RGANIZATION Therearethreemainformsofbusinessorganization:(1)proprietorships,(2)partner- ships, and (3) corporations. In terms of numbers, approximately 72 percent of businesses are operated as proprietorships, 8 percent are partnerships, and the remaining 20 percent are corporations. Based on the dollar value of sales, however, almost 85 percent of all business is conducted by corporations, while the remaining 15 percent is generated by both proprietorships (4 percent) and partnerships (11 percent).5 Becausemostbusinessisconductedbycorporations, wewillfocus on thatforminthisbook.However,itisimportanttounderstandthedifferencesamongthe threemajorformsofbusiness,aswellasthepopular‘‘hybrid’’formsofbusinessthat haveevolvedfromthesemajorforms. Proprietorship proprietorship Aproprietorshipisanunincorporatedbusinessownedbyoneindividual.Startinga An unincorporated proprietorshipisfairlyeasy—justbeginbusinessoperations.Inmanycases,however, businessownedbyone eventhesmallestbusinessmustbelicensedbythemunicipality(city,county,orstate) individual. in which itoperates. The proprietorship has three importantadvantages: 1. It is easily and inexpensively formed. 2. It is subject to few government regulations. Large firms that potentially threaten competition are much more heavily regulated than small ‘‘mom- and-pop’’ businesses. 3. It is taxed like an individual, not a corporation; thus, earnings are taxed only once. 5ThestatisticsprovidedinthissectionarebasedonbusinesstaxfilingsreportedbytheInternalRevenueService (IRS)in2006.AdditionalstatisticscanbefoundontheIRSwebsiteathttp://www.irs.ustreas.gov/tax_stats. Copyright 2008 Thomson Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Alternative FormsofBusinessOrganization 9 Licensed to: on Systems;cer (CIO) TaxDepartment matiOffi e President: InforChief Information Financial and Cost Accounting c Vi nance;er (CFO) ontroller d of Directors sident; Chiefve Office (CEO) Vice President: FiChief Financial Offic TreasurerC on Boar PreExecuti ons;COO) essOrganizati esident: Operatierating Officer ( Director of CapitalBudgeting Busin Vice Prhief Op al C Typic entory nager a nvMa n I i e nc s,ng na aleeti RoleofFi e President: Svice, and Mark CreditManager 1-1 VicSer E R U G FI Copyright 2008 Thomson Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. 10 Chapter 1 An Overview ofManagerial Finance The proprietorship also has four important limitations: Licensed to: 1. The proprietor has unlimited personal liability for business debts. With unlimitedpersonal liability, the proprietor (owner) can potentially lose all of hisorherpersonalassets,eventhoseassetsnotinvestedinthebusiness;thus, losses can farexceedthemoneythathe orshe has invested in the company. 2. Aproprietorship’slifeislimitedtothetimetheindividualwhocreateditownsthe business. When a new owner takes over the business, technically the firm becomesanewproprietorship(evenifthenameofthebusinessdoesnotchange). 3. Transferring ownership is somewhat difficult. Disposing of the business is similar to selling a house in that the proprietor must seek out and negotiate with a potential buyer. 4. Itisdifficultforaproprietorshiptoobtainlargesumsofcapitalbecausethefirm’s financialstrengthgenerallyisbasedonthefinancialstrengthofthesoleowner. Forthereasonsmentionedhere,individualproprietorshipsareconfinedprimarily tosmallbusinessoperations.Infact,onlyabout1percentofallproprietorshipshave assetsthatarevaluedat$1millionorgreater;nearly90percenthaveassetsvaluedat $100,000orless.However,mostlargebusinessesstartoutasproprietorshipsandthen convert to corporations when their growth causes the disadvantages of being a proprietorship—namely, unlimited personalliability—to outweigh the advantages. Partnership partnership Apartnershipisthesameasaproprietorship,exceptthatithastwoormoreowners. An unincorporated Partnershipscanoperateunderdifferentdegreesofformality,rangingfrominformal, businessownedbytwo oralunderstandingstoformalagreementsfiledwiththesecretaryofthestateinwhich ormore people. the partnership does business. Most legal experts recommend that partnership agreements be put in writing. The advantagesof a partnership are the same asfor a proprietorship: 1. Formation is easy and relatively inexpensive. 2. It is subject to few government regulations. 3. It is taxed like an individual, not a corporation. The disadvantages are also similarto thoseassociatedwith proprietorships: 1. Owners have unlimited personal liability. 2. The life of the organization is limited. 3. Transferring ownership is difficult. 4. Raising large amounts of capital is difficult. Under partnership law, each partner is liable for the debts of the business. Therefore, if any partner is unable to meet his or her pro rata claim in the event the partnership goes bankrupt, the remaining partners must make good on the unsatisfiedclaims,drawingontheirpersonalassetsifnecessary.Thus,thebusiness- relatedactivitiesofanyofthefirm’spartnerscanbringruintotheotherpartners,even thoughthosepartnersarenotadirectpartytosuchactivities. Thefirstthreedisadvantages—unlimitedliability,impermanenceoftheorganiza- tion, and difficulty of transferring ownership—lead to the fourth, the difficulty partnerships have in attracting substantial amounts of funds. This is not a major problemforaslow-growingbusiness.Butifabusiness’sproductsreallycatchonandit needstoraiselargeamountsoffundstocapitalizeonitsopportunities,thedifficultyin Copyright 2008 Thomson Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
The list of books you might like
