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Self-Test 1
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
these assets are tangible, such as machinery, factories, and offices; others are intangi-
Assets
REAL ASSETS
ble, such as technical expertise, trademarks, and patents. All of them must be paid for.
used to produce goods and
To obtain the necessary money, the company sells financial assets, or securities.3
services.
These pieces of paper have value because they are claims on the firm™s real assets and
the cash that those assets will produce. For example, if the company borrows money
FINANCIAL ASSETS
from the bank, the bank has a financial asset. That financial asset gives it a claim to a
Claims to the income
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) financial assets)
(3) (4b)
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
in which the firm raises cash. The financial manager™s role is shown in Figure 1.1,
FINANCIAL MARKETS
which traces how money flows from investors to the firm and back to investors again.
Markets in which financial
The flow starts when financial assets are sold to raise cash (arrow 1 in the figure). The
assets are traded.
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
should the cash required for an investment be raised? This is the financing decision.
CAPITAL BUDGETING
DECISION Decision as
to which real assets the firm
THE CAPITAL BUDGETING DECISION
should acquire.
Capital budgeting decisions are central to the company™s success or failure. For exam-
ple, in the late 1980s, the Walt Disney Company committed to construction of a Dis-
FINANCING DECISION
neyland Paris theme park at a total cost of well over $2 billion. The park, which opened
Decision as to how to raise
in 1992, turned out to be a financial bust, and Euro Disney had to reorganize in May
the money to pay for
1994. Instead of providing profits on the investment, accumulated losses on the park by
investments in real assets.
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
to the firm™s sources of long-term financing, and the markets for long-term financing
CAPITAL STRUCTURE
are called capital markets.5
Firm™s mix of long-term
Within the basic distinction”issuing new shares of stock versus borrowing money
financing.
”there are endless variations. Suppose the company decides to borrow. Should it go to
capital markets for long-term debt financing or should it borrow from a bank? Should
CAPITAL MARKETS
it borrow in Paris, receiving and promising to repay euros, or should it borrow dollars
Markets for long-term
in New York? Should it demand the right to pay off the debt early if future interest rates
financing.
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



Are the following capital budgeting or financing decisions?
Self-Test 2
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
choice is to borrow money from a financial intermediary like a bank or insurance
FINANCIAL
company. The financial intermediary, in turn, raises funds, often in small amounts, from
Firm
INTERMEDIARY
individual households. For example, a bank raises funds when customers deposit money
that raises money from many
into their bank accounts. The bank can then lend this money to borrowers.
small investors and provides
The bank saves borrowers and lenders from finding and negotiating with each other
financing to businesses or
directly. For example, a firm that wishes to borrow $2.5 million could in principle try
other organizations by
to arrange loans from many individuals:
investing in their securities.


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 deposits
Bank Investors and
Company
(intermediary) depositors
Cash
$2.5 million


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;
Insurance
Issues debt 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

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