10 Principles of Financial Management
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The 10 simple principles that do not require knowledge of finance to understand. However, while it is not necessary to understand finance in order to understand these principles, it is necessary to understand these principles in order to understand finance. Keep in mind that although these principles may at first appear simple or even trivial, they will provide the driving force behind all that follows. These principles will weave together concepts and techniques presented in this text, thereby allowing us to focus on the logic underlying the practice of financial management. In order to make the learning process easier for you as a student, we will keep returning to these principles throughout the book in the form of “Back to the Principles” boxes-tying the material together and letting you son the “forest from the trees.”
PRINCIPLE 1 The Risk-Return Trade-Off-We won’t take on additional risk unless we expect to be compensated with additional return. At some point, we have all saved some money. Why have we done this? The answer is simple: to expand our future consumption opportunities-for example, save for a house, a car, or retirement. We are able to invest those savings and earn a return on our dollars because some people would rather forgo future consumption opportunities to consumer now-maybe they’re borrowing money to open a new business or a company is borrowing money to build a new plant. Assuming there are a lot of different people that would like to use our savings, how do we decide where to put our money? First, investors demand a minimum return for delaying consumption that must be greater than the anticipated rate of inflation. If they didn’t receive enough to compensate for anticipated inflation, investors would purchase whatever goods they desired ahead of time or invest in assets that were subject to inflation and earn the rate of inflation on those assets.
There isn’t much incentive to postpone consumption if your savings are going to decline in terms of purchasing power. Investment alternatives have different amounts of risk and expected returns. Investors sometimes choose to put their money in risky investments because these investments offer higher expected returns. The more risk an investment has, the higher will be its expected return. Notice that we keep referring to expected return rather than actual return. We may have expectations of what the returns from investing will be, but we can’t peer into the future and see what those returns are actually going to be. If investors could see into the future, no one would have invested money in the software maker Citrix, whose stock dropped 46 percent on June 13, 2000.
Citrix’s stock dropped when it announced that unexpected problems in its sales channels would cause second-quarter profits to be about half what Wall Street expected. Until after the fact, you are never sure what the return on an investment will be. That is why General Motors bonds pay more interest than U.S. Treasury bonds of the same maturity. The additional interest convinces some investors to take on the added risk of purchasing a General Motors bond. This risk-return relationship will be a key concept as we value stocks, bonds, and proposed new projects throughout this text. We will also spend some time determining how to measure risk. Interestingly, much of the work for which the 1990 Nobel Prize for Economics was awarded centered on the graph in Figure 1-3 and how to measure risk. Both the graph and the risk-return relationship it depicts will reappear often in this text.
PRINCIPLE 2 The Time Value of Money-A dollar received today is worth more than a dollar received in the future A fundamental concept in finance is that money has a time value associated with it: A dollar received today is worth more than a dollar received a year from now. Because we can earn interest on money received today, it is better to receive money earlier rather than later. In your economics courses, this concept of the time value of money is referred to as the opportunity cost of passing up the earning potential of a dollar today. In this text, we focus on the creation and measurement of wealth. To measure wealth or value, we will use the concept of the time value of money to bring the future benefits and costs of a project back to the present.
Then, if the benefits outweigh the costs, the project creates wealth and should be accepted; if the costs outweigh the benefits, the project does not create wealth and should be rejected. Without recognizing the existence of the time value of money, it is impossible to evaluate projects with future benefits and costs in a meaningful way. To bring future benefits and costs of a project back to the present, we must assume a specific opportunity cost of money, or interest rate. Exactly what interest rate to use is determined by Principle 1: The Risk-Return Trade-Off, which states investors demand higher returns for taking on more risky project. Thus, when we determine the present value of future benefits and costs, we take into account that investors demand a higher return for taking on added risk.
PRINCIPLE 3 Cash-Not Profits-Is King In measuring wealth or value, we will use cash flows, not accounting profits, as our measurement tool. That is, we will be concerned with when the money hits our hand, when we can invest it and start earning interest on it, and when we can give it back to the shareholders in the form of dividends. Remember, it is the cash flows, not profits, that are actually received by the firm and can be reinvested. Accounting profits, however, appear when they are earned rather than when the money is actually in hand. As a result, a firms cash flows and accounting profits may not be the same. For example, a capital expense, such as the purchase of new equipment or a building, is depreciated over several years, with the annual depreciation subtracted from profits. However, the cash flow, or actual dollars, associated with this expense generally occurs immediately. Therefore cash inflows and outflows involve the actual receiving and payout of money-when the money hits or leaves your hands. As a result, cash flows correctly reflect the timing of the benefits and costs.
PRINCIPLE 4 Incremental Cash Flows-it is only what changes that counts In 2000, Post, the maker of Cocoa Pebbles and Fruity Pebbles, introduced Cinna Crunch Pebbles, “Cinnamon sweet taste that goes crunch.” There is no doubt that Cinna Crunch Pebbles competed directly with Posts other cereals and, in particular, it is Pebbles products. Certainly some of the sales dollars that ended up with Cinna Crunch Pebbles would have been spent on other Pebbles and Post products if Cinna Crunch Pebbles had not been available. Although Post was targeting younger consumers with this sweetened cereal, there is no question that Post sales bit into-actually cannibalized-sales from Pebbles and other Post lines. Realistically, there is only so much cereal anyone can eat. The difference between revenues Post generated after introducing Cinna Crunch Pebbles versus simply maintaining its existing line of cereals is the incremental cash flows. This difference reflects the true impact of the decision.
In making business decisions, we are concerned with the results of those decisions: What happens if we say yes versus what happens if we say no? Principle 3 states that we should use cash flows to measure the benefits that accrue from taking on a new project. We are now fine tuning our evaluation process so that we only consider incremental cash flows. The incremental cash flow is the difference between the cash flows if the project is taken on versus what they will be if the project is not taken on. What is important is that we think incrementally. Our guiding rule in deciding whether a cash flow is incremental is to look at the company with and without the new product. In fact, we will take this incremental concept beyond cash flows and look at all consequences from all decisions on an incremental basis.
PRINCIPLE 5 The Curse of Competitive Markets-Why it is hard to find exceptionally profitable projects. Our job as financial managers is to create wealth. Therefore, we will look closely at the mechanics of valuation and decision making. We will focus on estimating cash flows, determining what the investment earns, and valuing assets and new projects. But it will be easy to get caught up in the mechanics of valuation and lose sight of the process of creating wealth. Why is it so hard to find projects and investments that are exceptionally profitable? Where do profitable projects come from? The answers to these questions tell us a lot about how competitive markets operate and where to look for profitable projects. In reality, it is much easier evaluating profitable projects than finding them. If an industry is generating large profits, new entrants are usually attracted.
The additional competition and added capacity can result in profits being driven down to the required rate of return. Conversely, if an industry is returning profits below the required rate of return, then some participants in the market drop out, reducing capacity and competition. In turn, prices are driven back up. This is precisely what happened in the VCR video rental market in the mid-1980s. This market developed suddenly with the opportunity for extremely large profits. Because there were no barriers to entry, the market quickly was flooded with new entries. By 1987, the competition and price cutting produced losses for many firms in the industry, forcing them to flee the market. As the competition lessened with firms moving out of the video rental industry, profits again rose to the point where the required rate of return could be earned on invested capital. In competitive markets, extremely large profits simply cannot exist for very long. Given that somewhat bleak scenario, how can we find good projects-that is, projects that return more than their expected rate of return given their risk level (remember Principle 1).
Although competition makes them difficult to find, we have to invest in markets that are not perfectly competitive. The two most common ways of making markets less competitive are to differentiate the product in some key way or to achieve a cost advantage over competitors. Product differentiation insulates a product from competition, thereby allowing a company to charge a premium price. If products are differentiated, consumer choice is no longer made by price alone. For example, many people are willing to pay a premium for Starbucks coffee. They simply want Starbucks and price is not important. In the pharmaceutical industry, patents create competitive barriers. Schering-Ploughs Claritin, an allergy relief medicine, and Hoffman-La Roches Valium, a tranquilizer, are protected from direct competition by patents. Service and quality are also used to differentiate products.
For example, Levis has long prided itself on the quality of its jeans. As a result, it has been able to maintain its market share. Similarly, much of Toyota and Hondas brand loyalty is based on quality Service can also create product differentiation, as shown by McDonalds fast service, cleanliness, and consistency of product that brings customers back. Whether product differentiation occurs because of advertising, patents, service, or quality, the more the product is differentiated from competing products, the less competition it will face and the greater the possibility of large profits. Economies of scale and the ability to produce at a cost below competition can effectively deter new entrants to the market and thereby reduce competition. Wal-Mart is one such case. For Wal-Mart, the fixed costs are largely independent of the stores size. For example, inventory costs, advertising expenses, and managerial salaries are essentially the same regardless of annual sales.
Therefore, the more sales that can be built up, the lower the per-sale dollar cost of inventory, advertising, and management. Restocking from warehouses also becomes more efficient as delivery trucks can be used to full potential. Regardless of how the cost advantage is created-by economies of scale, proprietary technology, or monopolistic control of raw materials-the cost advantage deters new market entrants while allowing production at below industry cost. This cost advantage has the potential of creating large profits. The key to locating profitable investment projects is to first understand how and where they exist in competitive markets.
Then the corporate philosophy must be aimed at creating or taking advantage of some imperfection in these markets, either through product differentiation or creation of a cost advantage, rather than looking to new markets or industries that appear to provide large profits. Any perfectly competitive industry that looks too good to be true won’t be for long. It is necessary to understand this to know where to look for good projects and to accurately measure the projects cash flows. We can do this better if we recognize how wealth is created and how difficult it is to create it.
PRINCIPLE 6 Efficient Capital Markets-The markets are quick and the prices are right. Our goal as financial managers is the maximization of shareholder wealth. How do we Efficient market measure shareholder wealth? It is the value of the shares that the shareholders hold. To a market in which the values of all assets and securities at any understand what causes stocks to change in price, as well as how securities such as bonds instant in time fully reflect all and stocks are valued or priced in the financial markets, it is necessary to have an under available public information standing of the concept of efficient markets. Whether a market is efficient or not has to do with the speed with which information is impounded into security prices. An efficient market is characterized by a large number of profit-driven individuals who act independently. In addition, new information regarding securities arrives in the market in a random manner.
Given this setting, investors adjust to new information immediately and buy and sell the security until they feel the market price correctly reflects the new information. Under the efficient market hypothesis, information is reflected in security prices with such speed that there are no opportunities for investors to profit from publicly available information. Investors competing for profits ensure that security prices appropriately reflect the expected earnings and risks involved and thus the true value of the firm.
What are the implications of efficient markets for us? First, the price is right. Stock prices reflect all publicly available information regarding the value of the company. This means we can implement our goal of maximization of shareholder wealth by focusing on the effect each decision should have on the stock price if everything else were held constant. That is, over time good decisions will result in higher stock prices and bad ones, lower stock prices. Second, earnings manipulations through accounting changes will not result in price changes. Stock splits and other changes in accounting methods that do not affect cash flows are not reflected in prices. Market prices reflect expected cash flows available to shareholders. Thus, our preoccupation with cash flows to measure the timing of the benefits is justified. As we will see, it is indeed reassuring that prices reflect value. It allows us to look at prices and see value reflected in them. While it may make investing a bit less exciting, it makes corporate finance much less uncertain.
The Agency Problem-Managers won’t work for owners unless it is in their best interest. Although the goal of the firm is the maximization of shareholder wealth, in reality, the agency problem may interfere with the implementation of its goal. The agency problem results from the separation of management and the ownership of the firm. For example Problem resulting from, a large firm may be nm by professional managers who have little or no ownership in conflicts of interest between the manager (the stockholders the firm. Because of this separation of the decision makers and owners, managers may agent) and the stockholders make decisions that are not in line with the goal of maximization of shareholder wealth. They may approach work less energetically and attempt to benefit themselves in terms of salary and perquisites at the expense of shareholders. To begin with, an agent is someone who is given the authority to act on behalf of another, referred to as the principal. In the corporate setting, the shareholders are the principals, because they are the actual owners of the firm. The board of directors, the CEO, the corporate executives, and all others with decision-making power are agents of the shareholders.
Unfortunately, the board of directors, the CEO, and the other corporate executives don’t always do what’s in the best interest of the shareholders. Instead, they act many times in their own best interest. Not only might they benefit themselves in terms of salary and perquisites, but they might also avoid any projects that have risk associated with them-even if they’re great projects will huge potential returns and a small chance of failure. Why is this so? Because if the project doesn’t turn out, these agents of the shareholders may lose their jobs. The costs associated with the agency problem are difficult to measure, but occasionally we see the problems effect in the marketplace. For example, if the market feels management of a firm is damaging shareholder wealth, we might see a positive reaction in stock price to the removal of that management. In 1989, on the day following the death of JohnDorrance, Jr., chairman of Campbell Soup, Campbells stock price rose about 15 percent.
Some investors felt that Campbells relatively small growth in earnings might be improved with the departure of Dorrance. There was also speculation that Dorrance was the major obstacle to a possible positive reorganization. If the management of the firm works for the owners, who are the shareholders, why doesn’t the management get fired if it doesn’t act in the shareholders best interest? In theory, the shareholders pick the corporate board of directors and the board of directors in turn picks the management. Unfortunately, in reality the system frequently works the other way around. Management selects the board of director nominees and then distributes the ballots. In effect, shareholders are offered a slate of nominees selected by the management. The end result is management effectively selects the directors, who then may have more allegiance to managers than to shareholders.
This in turn sets up the potential for agency problems with the board of directors not monitoring managers on behalf of the shareholders as they should. We will spend considerable time monitoring managers and trying to align their interests with shareholders. Managers can be monitored by auditing financial statements and manager compensation packages. The interests of managers and shareholders can be aligned by establishing management stock options, bonuses, and perquisites that are directly tied to how closely their decisions coincide with the interest of shareholders. The agency problem will persist unless an incentive structure is set up that aligns the interests of managers and shareholders. In other words, what’s good for shareholders must also be good for manager. If that is not the case, managers will make decisions in their best interests rather than maximizing shareholder wealth.
PRINCIPLE 8 Taxes Bias Business Decisions- Hardly any decision is made by the financial manager without considering the impact of taxes. When we introduced Principle 4, we said that only incremental cash flows should be considered in the evaluation process. More specifically, the cash flows we will consider will be after-tax incremental cash flows to the firm as a whole. When we evaluate new projects, we will see income taxes playing a significant role. When the company is analyzing the possible acquisition of a plant or equipment, the returns from the investment should be measured on an after-tax basis. Otherwise, the company will not truly be evaluating the true incremental cash flows generated by the project. The government also realizes taxes can bias business decisions and uses taxes to encourage spending in certain ways. If the government wanted to encourage spending on research and development projects it might offer an investment tax credit for such investments.
This would have the effect of reducing taxes on research and development projects, which would in turn increase the after-tax cash flows from those projects. The increased cash flow would turn some otherwise unprofitable research and development projects into profitable projects. In effect, the government can use taxes as a tool to direct business investment to research and development projects, to the inner cities, and to projects that create jobs. PRINCIPLE 9 All Risk Is Not Equal-Some risk can be diversified away, and some cannot much of finance centers around Principle 1: The Risk-Retunt Trade-Off. But before we can fully use Principle 1, we must decide how to measure risk. As we will see, risk is difficult to measure. Principle 9 introduces you to the process of diversification and demonstrates how it can reduce risk. We will also provide you with an understanding of how diversification makes it difficult to measure a projects or an assets risk. You are probably already familiar with the concept of diversification.
There is an old saying, “don’t put all of your eggs in one basket.” Diversification allows good and bad events or observations to cancel each other out, thereby reducing total variability without affecting expected return. To see how diversification complicates the measurement of risk, let us look at the difficulty Louisiana Gas has in determining the level of risk associated with a new natural gas well drilling project. Each year, Louisiana Gas might drill several hundred wells, with each well having only a 1 in 10 chance of success. If the well produces, the profits are quite large, but if it comes up dry, the investment is lost. Thus, with a 90 percent chance of losing everything, we would view the project as being extremely risky. However, if Louisiana Gas each year drills 2,000 wells, all with a 10 percent, independent chance of success, then they would typically have 200 successful wells. Moreover, a bad year may result in only 190 successful wells, and a good year may result in 210 successful wells. If we look at all the wells together, the extreme good and bad results tend to cancel each other out and the well drilling projects taken together do not appear to have much risk or variability of possible outcome.
The amount of risk in a gas well project depends upon our perspective. Looking at the well standing alone, it looks like a lot; however, if we consider the risk that each well contributes to the overall firm risk, it is quite small. This is because much of the risk associated with each individual well is diversified away within the firm. The point is: We can’t look at a project in isolation. Later, we will see that some of this risk can be further diversified away within the shareholders portfolio. Perhaps the easiest way to understand the concept of diversification is to look at it graphically. Consider what happens when we combine two projects, as depicted in Figure1-4. In this case, the cash flows from these projects move in opposite directions, and when they are combined, the variability of their combination is totally eliminated. Notice at the return has not changed-each individual projects and their combinations return averages 10 percent. In this case, the extreme good and bad observations cancel each other out.
The degree to which the total risk is reduced is a function of how the two sets of cash flows or returns move together. As we will see for most projects and assets, some risk can be eliminated through diversification, whereas some risk cannot. This will become an important distinction later in our studies. For now, we should realize that the process of diversification can reduce risk, and as a result, measuring a projects or an assets risk is very difficult. A projects risk changes depending on whether you measure it standing alone or together with other projects the company may take action. See the Finance Matters box,
PRINCIPLE 10 Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance Ethics, or rather a lack of ethics, in finance is a recurring theme in the news. During the late 1980s and early 1990s, the fall of Ivan Boesky and Drexel, Burnham, Lambert, and the near collapse of Salomon Brothers seemed to make continuous headlines. Meanwhile, the movie “Wall Street was a hit at the box office and the book Liars Poker, by Michael Lewis, chronicling unethical behavior in the bond markets, became a best seller. Unfortunately, ethics, or the lack of them, continued to make the front page in the early 2000s, with Enron, Worldcom, and Arthur Anderson all serving to illustrate that ethical errors are not forgiven in the business world. Not only is acting in an ethical manner morally correct, it is congruent with our goal of maximization of share- holder wealth. Ethical behavior means “doing the right thing.” A difficulty arises, however, in attempting to define “doing the right thing.”
The problem is that each of us has his or her own set of values, which forms the basis for our personal judgments about what is the right thing to do. However, every society adopts a set of rules or laws that prescribe what it believes to be “doing the right thing.” In a sense, we can think of laws as a set of rules that reflect the values of the society as a whole, as they have evolved. For purposes of this text, we recognize that individuals have a right to disagree about what constitutes “doing the right thing,” and we will seldom venture beyond the basic notion that ethical conduct involves abiding by societies rules. However, we will point out some of the ethical dilemmas that have arisen in recent years with regard to the practice of financial management. So as we embark on our study of finance and encounter ethical dilemmas, we encourage you to consider the issues and form your own opinions. Many students ask, “Is ethics really relevant?” This is a good question and deserves an answer. First, although business errors can be forgiven, ethical errors tend to end careers and terminate future opportunities.
Why? Because unethical behavior eliminates trust, and without trust, businesses cannot interact. Second, the most damaging event a business can experience is a loss of the publics confidence in its ethical standards. In finance, we have seen several recent examples of such events. It was the ethical lapses at Arthur Anderson and its work with Enron that brought down that once-great accounting firm. See the Finance Matters box, “The Wall Street Journal Workplace-Ethics Quiz.” Beyond the question of ethics is the question of social responsibility. In general, corporate social responsibility means that a corporation has responsibilities to society beyond the maximization of shareholder wealth. It asserts that a corporation answers to a broader constituency than shareholders alone. As with most debates that center on ethical and moral questions, there is no definitive answer.
One opinion is that because financial managers are employees of the corporation, and the corporation is owned by the shareholders, the financial managers should run the corporation in such a way that share- holder wealth is maximized and then allow the shareholders to decide if they would like to fulfill a sense of social responsibility by passing on any of the profits to deserving causes. Very few corporations consistently act in this way. For example, Bristol-Myers Squibb Co. is away heart medication to those who cannot pay for it. This decision to give away heart medication came in the wake of an American Heart Association report showing that many of the nations working poor face severe health risks because they can- not afford heart drugs. Clearly, Bristol-Myers Squibb felt it had a social responsibility to provide this medicine to the poor at no cost. How do you feel about this decision?
A FINAL NOTE ON THE PRINCIPLES Hopefully, these principles are as much statements of common sense as they are theoretical statements. These principles provide the logic behind what is to follow. We will build on them and attempt to draw out their implications for decision making. As we continue, try to keep in mind that although the topics being treated may change from chapter to chapter, the logic driving our treatment of them is constant and is rooted in these 10 principles.