1. PE~RSONLow PRICE EDITION ~Education

2. BR tE,F~e.O,N TEN TS Preface xviiP.ART 1: THE SCOPE AND ENVIRONMENTOF FINANCIAL MANAGEMENT CHAPTER 1 An Introduction to Financial Management 3 CH~PTER 2 Und,brstanding Financial Statements, Taxes, and Cash Flows 31 CHAPTER 3I-- Evaluating a Firms Financial Performance 71 CHAPTER 4 Financial Forecasting, Planning, and Budgeting 107PART 2: VALUATION OF FINANCIAL ASSETS CHAPTER 5 The Value of Money 137 CHAPTER 6 Risk and Rates of Return 181 CHAPTER 7 Valuation and Characteristics of Bonds 22 3 CHAPTER 8 Stock Valuation 255PART 3: INVESTMENT IN LONG-TERM ASSETS CHAPTER 9 Capital Budgeting Decision Criteria 289 CHAPTER 10 Cash Flows and Other Topics in Capital Budgeting 327 CHAPTER 11 Capital Budgeting and Risk Analysis 371 CHAPTER 12 Cost of Capital 405 CHAPTER 13 Managing for Shareholder Value 435 vii 3. viii BRIEF CONTENTS, PART 4: CAPITAL STRUCTURE AND DIVIDEND POLICYCHAPTER14Raising Capital in the Financial Markets 469CHAPTER 15Analysis and Impact of Leverage 505CHAPTER 16Planning the Firms Financing Mix 551CHAPTER 17Dividend Policy and Internal Financing 605 PART 5: WORKING-CAPITAL MANAGEMENT AND SPECIAL TOPICS IN FINANCECHAPTER 18Working-Capital Management and Short-Term Financing 645CHAPTER 19Cash and Marketable Securities Management 673CHAPTER 20Accounts Receivable and Inventory Management 705 PART 6: SPECIAL TOPICS IN FINANCECHAPTER 21Risk Management 739CHAPTER 22International Business Finance 773CHAPTER 23Corporate Restructuring: Combinations and Divestitures* 23-1CHAPTER 24Term Loans and Leases* 24-1Appendixes A-IGlossary G-lIndexes I-I*Chapters 23 and 24 can be found at www.prenhall.comlkeown 4. CONTENT:SPrefaceXVii PART 1: THE SCOPE AND ENVIRONMENT . - OFFINANCIAL MANAGEMENT --- - --CHAPTER 1An Introduction to Financial Management 3What Is Finance? 4Goal of the Firm 4Legal Forms of Business Organization 7Ten Principles That Form the Basics of Financial Management 12PRINCIPLE 1: The Risk-Return Trade-Off-We wont take on additional risk unless we expect to be compensated with additional return 13PRINCIPLE 2: The Time Value of Money-A dollar received today is worth more than a dollar received in the future 14PRINCIPLE 3: Cash-Not Profits-Is King 14PRINCIPLE 4: Incremental Cash Flows-Its only what changes that counts 15 -----PRINCIPLE 5: The Curse of Competitive Markets-Why its hard to find exceptionally profitable projects 15PRINCIPLE 6: Efficient Capital Markets-The markets are quick and the prices are right 16PRINCIPLE 7: The Agency Problems-Managers wont work for owners unless its in their best interest 17PRiNCIPLE 8: Taxes Bias Business Decisions 18PRINCIPLE 9: All Risk Is Not Equal-Some risk can be diversified away, and some cannot 18PRINCIPLE 10: Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance 20Overview of the Text 22Finance and the Multinational Firm: The New Role 24How Financial Managers Use This Material 25Summary 25--/ CHAPTER 2Understanding Financial Statements, Taxes, and Cash Flows 31 The Income Statement: Measuring a Companys Profits 32 The Balance Sheet: Measuring a Firms Book Value 34 Computing a Companys Taxes 41 Measuring Free Cash Flows 44 Financial Statements and International Finance 49 How Financial Managers Use This Material 50 Summary 50 Appendix 2A: Measuring Cash Flows: An Accounting Perspective 66 ix 5. x CONTENTS JCHAPTER 3 Evaluating a Firms Financial Performance71Financial Ratio Analysis 72The DuPont Analysis: An Integrative Approach to Ratio Analysis 85How Financial Managers Use This Material 89Summary 89CHAPTER 4Financial Forecasting, Planning, and Budgeting107Financial Forecasting 108Limitations of the Percent of Sales Forecast Method 113The Sustainable Rate of Growth 115Financial Planning and Budgeting 117How Financial Managers Use This Material 120Summary 120PART 2: VALUATION OF FINANCIAL ASSETS.,j CHAPTER 5The Time Value of Money 137Compound Interest and Future Value 138Compound Interest with Nonannual Periods 146Present Value 147Annuities-A Level Stream 150Annuities Due 157Present Value of Complex Stream 160Perpetuities and Infinite Annuities 163Making Interest Rates Comparable 163The Multinational Firm: The Time Value of Money 164How Financial Managers Use This Material 165Summary 165 ,/ CHAPTER 6Risk and Rates of Return181Rates of Return in the Financial Markets 182The Effects of Inflation on Rates of Return and the Fisher Effect 184The Term Structure of Interest Rates 185Expected Return 187Risk 188Risk and Diversification 192Measuring Market Risk 196Measuring a Portfolios Beta 201The Investors Required Rate of Return 203How Financial Managers Use This Material 207Summary 208 6. CONTENTS xij CHAPTER 7 Valuation and Characteristics of Bonds 223 Types of Bonds 224 Terminology and Characteristics of Bonds 22 7 Definitions of Value 231 Determinants of Value 232 Valuation: The Basic Process 234 Bond Valuation 235 The Bondholders Expected Rate of Return (Yield to Maturity) 238 Bond Valuation: Five Important Relationships 240 How Financial Managers Use This Material 246 Summary 246 / CHAPTER 8 Stock Valuation255 Features and Types of Preferred Stock 256 Valuing Preferred Stock 259 Characteristics of Common Stock 261 Valuing Common Stock 267 Stockholders Expected Rate of Return 272 How Financial Managers Use This Material 275 Summary 275 Appendix 8A: The Relationship between Value and Earnings 283PAR T 3: I N VE S T MEN TIN LON G - T E R MAS SET S CHAPTER 9 Capital-Budgeting Decision Criteria 289 Finding Profitable Projects 290 Payback Period 292 Net Present Value 295 Profitability Index (Benefit/Cost Ratio) 298 Internal Rate of Return 299 Ethics in Capital Budgeting 312 A Glance at Actual Capital-Budgeting Practices 313 How Financial Managers Use This Material 314 Summary 315 CHAPTER 10 Cash Flows and Other Topics in Capital Budgeting327 Guidelines for Capital Budgeting 328 An Overview of the Calculations of a Projects Free Cash Flows 332 Complications in Capital Budgeting: Capital Rationing and Mutually Exclusive Projects 344I~ 7. xii CONTENTS The Multinational Firm: International Complications in Calculating Expected Free Cash Flows 353 How Financial Managers Use This Material 353 Summary 354 CHAPTER11 Capital Budgeting and Risk Analysis 371 Risk and the Investment Decision 372 Methods for Incorporating Riskinto Capital Budgeting 376 Other Approaches to Evaluating Risk in Capital Budgeting 383 The Multinational Firm: Capital Budgeting and Risk 389 How Financial Managers Use This Material 390 Summary 390 CHAPTER12 Cost of Capital405 The Cost of Capital: Key Definitions and Concepts 406 Determining Individual Costs of Capital 407 The Weighted Average Cost of Capital 414 Cost of Capital in Practice: Briggs & Stratton 417 Calculating Divisional Costs of Capital: PepsiCo, Inc. 419 Using a Firms Cost of Capital to Evaluate New Capital Investments 420 How Financial Managers Use This Material 424 Summary 424 CHAPTER13 Managing for Shareholder Value 435 Who Are the Top Creators of Shareholder Value? 437 Business Valuation-The Key to Creating Shareholder Value 438 Value Drivers 443 Economic Value Added (EVA) 445 Paying for Performance 448 How Financial Managers Use This Material 456 Summary 457PART 4: CAPITAL STRUCTURE AND DIVIDEND POLICY CHAPTER14 Raising Capital in the Financial Markets 469 The Financial Manager, Internal and External Funds, and Flexibility 472 The Mix of Corporate Securities Sold in the Capital Market 474 Why Financial Markets Exist 475 Financing of Business: The Movement of Funds Through the Economy 478 Components of the U.S. Financial Market System 481 The Investment Banker 489 More on Private Placements: The Debt Side 493 8. CONTENTS xiiiFlotation Costs 494Regulation 495The Multinational Firm: Efficient Financial Markets and Intercountry Risk 499How Financial Managers Use This Material 500?ummary 501CHAPTER 15Analysis and Impact of Leverage 505Business and Financial Risk 506Break-Even Analysis 509Operating Leverage 519Financial Leverage 524Combination of Operating and Financial Leverage 527The Multinational Firm: Business Risk and Global Sales 531How Financial Managers Use This Material 532Summary 533CHAPTER 16Planning the Firms Financing Mix551Key Terms and Getting Started 552A Glance at Capital Structure Theory 553Basic Tools of Capital Structure Management 568The Multinational Firm: Beware of Currency Risk 580How Financial Managers Use This Material 581Summary 587CHAPTER 17Dividend Policy and Internal Financing605Dividend Payment Versus Profit Retention 607Does Dividend Policy Affect Stock Price? 608The Dividend Decision in Practice 621Dividend Payment Procedures 625Stock Dividends and Stock Splits 625Stock Repurchases 628The Multinational Firm: The Case of Low Dividend Payments-So Where Do WeInvest? 631How Financial Managers Use This Material 633Summary 633 PART 5: WORKING-CAPITAL MANAGEMENT AND S P E C I A L TOP I C SIN FIN A N C.ECHAPTER 18Working-Capital Management and Short-Term Financing645Managing Current Assets and Liabilities 646Financing Working Capital with Current Liabilities 647 j 9. xiv CONTENTSAppropriate Level of Working Capital 648Hedging Principles 648Cash Conversion Cycle 651Estimation of the Cost of Short-Term Credit 653Sources of Short-Term Credit 654Multinational Working-Capital Management 661How Finance Managers Use This Material 662Summary 662CHAPTER 19Cash and Marketable Securities Management673What are Liquid Assets? 674Why a Company Holds Cash 674Cash-Management Objectives and Decisions 676Collection and Disbursement Procedures 678Composition of Marketable Securities Portfolio 684The Multinational Firm: The Use of Cash and Marketable Securities 691How Financial Managers Use This Material 691Summary 691CHAPTER 20Accounts Receivable and Inventory Management705Accounts Receivable Management 706Inventory Management 716TQM and Inventory-Purchasing Management: The New SupplierRelationships 724How Financial Managers Use This Material 727Summary 728 ". ./ CHAPTER 21Risk Management739Futures 740Options 746Currency Swaps 757The Multinational Firm and Risk Management 758How Financial Managers Use This Material 759Summary 759CHAPTER 22International Business Finance 773The Globalization of Product and Financial Markets 774Exchange Rates 775Interest-Rate Parity Theory 785Purchasing-Power Parity 785Exposure to Exchange Rate Risk 787Multinational Working-Capital Management 791 10. CONTENTS xvInternational Financing and Capital-Structure Decisions 793Direct Foreign Investment 794How Financial Managers Use This Material 796Swnmary 796.1~ CHAPTER 23~Corporate Restructuring: Combinations and Divestitures 23-1Why Mergers Might Create Wealth 23-3Determination of a Firms Value 23-6Divestitures 23-14How Financial Managers Use This Material 23-17Summary 23-19 ~ CHAPTER 24 - , Term Loans and Leases24-1Term Loans 24-3Loan Payment Calculation 24-5Leases 24-7The Economics of Leasing Versus Purchasing 24-16How Financial Managers Use This Material 24-20Summary 24-20Appendixes A-IGlossary G-lIndexes I-I*Chapters 23 and 24 can be found at www.prenhall.comlkeown 11. CHAPTER 1AN I NTRO DUCTI 0 N TO FINANCIAL MANAGEMENTCHAPTER 2UNDERSTANDING FINANCIALSTATEMENTS, TAXES, AND CASH FLOWSCHAPTER 3EVALUATI NG AFIRMS FINANCIAL PERFORMANCECHAPTER 4 FI NAN CIALFORECASTING, PLANNING, ANDBUDGETING 12. CHAPTER 1 An Introd uctionto Financial ManagementIn 1985, Harley-Davidson teetered only hours away from banka successful stock offering, and Spring 2003, Harleys stockruptcy as one of Harleys largest lenders, Citicorp Industrialprice rose approximately 125-fold. How did Harley-Davidson, aCredit, was considering bailing out on its loan. Since its begin company whose name grown men and women have tattooedning in 1903, the company survived two world wars, the Greaton their arms and elsewhere, a company that conjures upDepression, and competition from countless competitors, but images of burly bad boys and Easy Rider hippies in black leatherby the early 1980s, Harley had become known for questionablejackets riding down the road, pull off one of the biggest busireliability and leaving oil stains on peoples driveways. It looked ness turnarounds of all time? Harley made good decisions.for a while like the future was set, and Harley wouldnt be Thats what were going to look at in this book. Well look atthere. It looked like the future of motorcycles in America wouldwhat it takes to turn Harley or any other company around.feature only Japanese names like Honda, Yamaha, Kawasaki, Well look at how a company goes about making decisions toand Suzuki. But none of that happened, and today Harleyintroduce new product lines. For example, in 2003, HarleyDavidson stands, as President Reagan once proclaimed, as "anDavidson introduced the Buell Lightning Low XB95, a low-cost,American success story." For a company in todays world, sur lightweight bike with a lower seat height aimed at bringingviving one scare is not enough-Today the business world shorter riders into the sport. How did it make this decision?involves a continuous series of challenges. As for Harley, it was Well also follow Harley-Davidson throughout this book, exama major accomplishment to make it through the 1980s, allow ining how its experience fits in with the topics we are examining it to face another challenge in the 1990s: a market thating. In doing so, we will see that there are countless interaclooked like it might disappear within a few years. How didtions among finance, marketing, management, and accounting.Harley do against what looked like a shrinking market? It Because finance deals with decision making, it takes on imporincreased its motorcycle shipments from just over 60,000 in tance, regardless of your major. Moreover, the tools, techniques,1990 to over 260,000 in 2002 with expected sales in 2003 of and understanding you will gain from finance will not only helparound 290,000! How have the shareholders done? Between you in your business career, but will also help you make edu1986, when Harley-Davidson returned to public ownership withcated personal investment decisionsin the future.~CHAPTER PREVIEW ~ In this chapter, we will lay a foundation for the entire decisions. Then, we will describe the golden thread book. We will explain what finance is, and then we that ties everything together: the 10 basic principles will explain the key goal that guides financial deciof finance. Finally, we will look at the importance of sion making: maximization of shareholder wealth. looking beyond our geographic boundaries. We will examine the legal environment of financial3 13. 4 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENTObjective ~WHAT IS FINANCE?Financial management is concerned with the maintenance and creation of economicvalue or wealth. Consequently, this course focuses on decision making with an eye towardcreating wealth. As such, we will deal with financial decisions such as when to introduce anew product, when to invest in new assets, when to replace existing assets, when to borrow from banks, when to issue stocks or bonds, when to extend credit to a customer, andhow much cash to maintain.To illustrate, consider two firms, Merck and General Motors (GM). At the end of2003, the total market value of Merck, a large pharmaceutical company, was $103 billion.Over the life of the business, Mercks investors had invested about $30 billion in the business. In other words, management created $73 billion in additional wealth for the shareholders. GM, on the other hand, was valued at $30 billion at the end of 2003; but over theyears, GMs investors had actually invested $85 billion-a loss in value of $55 billion.Therefore, Merck created wealth for its shareholders, while GM lost shareholder wealth.In introducing decision-making techniques,we will emphasize the logic behind thosetechniques, thereby ensuring that we do not lose sight of the concepts when dealing withthe calculations. To the first-time student of finance, this may sound a bit overwhelming.However, as we will see, the techniques and tools introduced in this text are all motivated by10 underlying principles or axioms that will guide us through the decision-making process.Objective ~GOAL OF THE FIRMWe believe that the preferable goal of the firm should be maximization of shareholderwealth, by which we mean maximization of the price of the existing common stock. Notonly will this goal be in the best interest of the shareholders, but it will also provide themost benefits to society. This will come about as scarce resources are directed to theirmost productive use by businesses competing to create wealth.To better understand this goal, we will first discuss profit maximization as a possiblegoal for the firm. Then we will compare it to maximization of shareholder wealth to seewhy, in financial management, the latter is the more appropriate goal for the firm.PROFIT MAXIMIZATIONIn microeconomics courses, profit maximization is frequently given as the goal of thefirm. Profit maximization stresses the efficient use of capital resources, but it is not specific with respect to the time frame over which profits are to be measured. Do we maximize profits over the current year, or do we maximize profits over some longer period? Afinancial manager could easily increase current profits by eliminating research and development expenditures and cutting down on routine maintenance. In the short run, thismight result in increased profits, but this clearly is not in the best long-run interests of thefirm. If we are to base financial decisions ona goal, that goal must be precise, not allowfor misinterpretation, and deal with all the complexities of the.real world. In microeconomics, profit maximization functions largely as a theoretical goal, witheconomists using it to prove how firms behave rationally to increase profit. Unfortunately,it ignores many real-world complexities that financial managers must address in their decisions. In the more applied discipline of financial management, firms must deal every daywith two major factors not considered by the goal of profit maximization: uncertainty andtiming. Microeconomics courses ignore uncertainty and risk to present theory more easily.Projects and investment alternatives are compared by examining their expected values or 14. CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 5weighted average profits. Whether one project is riskier than another does not enter intothese calculations; economists do discuss risk, but only tangentially.! In reality, projectsdiffer a great deal with respect to risk characteristics, and to disregard these differences inthe practice of financial management can result in incorrect decisions. As we will discoverlater in this chapter, there is a very definite relationship between risk and expectedreturn-that is, investors demand a higher expected return for taking on added risk-andto ignore this relationship would lead to improper decisions. Another problem with the goal of profit maximization is that it ignores the timing ofthe projects returns. If this goal is only concerned with this years profits, we know itinappropriately ignores profit in future years. If we interpret it to maximize the average offuture profits, it is also incorrect. Inasmuch as investment opportunities are available formoney in hand, we are not indifferent to the timing of the returns. Given equivalent cashflows from profits, we want those cash flows sooner rather than later. Thus the real-worldfactors of uncertainty and timing force us to look beyond a simple goal of profit maximization as a decision criterion. Finally, and possibly most important, accounting profits fail to recognize one of themost important costs of doing business. When we calculate accounting profits, we consider interest expense as a cost of borrowing money, but we ignore the cost of the fundsprovided by the firms shareholders (owners). If a company could earn 8 percent on a newinvestment, that would surely increase the firms profits. However, what if the firmsshareholders could earn 12 percent with that same money in another investment of similar risk? Should the companys managers accept the investment because it will increasethe firms profits? Not if they want to act in the best interest of the firms owners (shareholders). Now look at what happened with Burlington Northern. Burlington Northern is a perfect example of erroneous thinking. In 1980, RichardBressler was appointed as Chief Executive Officer (CEO) of the company. Bressler,unlike his predecessor, was not a "railroad man." He was an "outsider" who was hired forthe express purpose of improving the value of the shareholders stock. The reason for thechange was that Burlington Northern had been earning about 4 percent on the shareholders equity, when Certificates of Deposit (CDs) with no risk were paying 6 percent.Management was certainly increasing the firms profits, but they were destroying shareholder wealth by investing in railroad lines that were not even earning a rate of returnequal to that paid on government securities. We will turn now to an examination of amore robust goal for the firm: maximization of shareholder wealth. -~MAXIMIZATION OF SHAREHOLDER WEALTHIn formulating the goal of maximization of shareholder wealth, we are doing nothingmore than modifying the goal of profit maximization to deal with the complexities of theoperating environment. We have chosen maximization of shareholder wealth-that is,maximization of the market value of the existing shareholders common stock-becausethe effects of all financial decisions are thereby included. Investors react to poor investment or dividend decisions by causing the total value of the firms stock to fall, ano theyreact to good decisions by pushing up the price of the stock. In effect, under this goal,good decisions are those that create wealth for the shareholder. Obviously, there are some serious practical problems in implementing this goal andin using changes in the firms stock to evaluate financial decisions. We know the price ofa firms stock fluctuates, often for no apparent r(ason. However, over the long run, priceequals value. We will keep this long-run balancing in mind and focus on the effect thatI See, for example, Robert S. Pindyck and Daniel Rubenfield, MiC7OecQlwlIIics, 2d ed. (New York: MacmiUan, !992),244--46. I: }...J........ 15. 6PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENTFINANCE- ..... . < ~~.. ,.. ~ , ~ ~.-I":~ ... -4#.ETHICS~ ~". k-~ - c- C . S Y "" - ~;r., I -~ . ... _ ,THE ENRON LESSONSOn December 2, 2001 the Enron Corporation (Houston,everything (more than $48 billion), and there was not nearly .TX) declared bankruptcy. Enrons failure shocked the busi the public outcry over this bankruptcy.ness community because of the size and prominence of thefinn. Perhaps most telling is the fact that Enron Corp. hadFailure of the Public Reporting Processbeen named the most innovative company in America by What weve learned about the deep seeded problems atF01tune Magazine for six srraight years, with the most recentEnron after the firms failure has led many investors to quesaward being made in January 2001. The Enron failure dom tion the adequateness of public reporting. For example,inated the financial press for months thereafter and alsowhere were the analysts and credit rating agencies, since noresulted in a series of high profile congressional hearings. early warning was sounded? Where were the firms auditorsThroughout this book we will be presenting the lessons and why were they not reporting what appear in hindsight tolearned from Enron in a series of boxes, but first, here is an be a blatant disregard for standard reporting practice to theassessment of why there was so much public concern overboard of directors auditor committee? Speaking of which,the event. where was the firms board of directors and why were theyIn a capitalistic economy firms are formed by enrre not questioning some of Enrons related party rransactions?preneurs-some grow to be large, publicly traded firmsIt would appear that an important source of the publiclike Enron, and many of them eventually fail. So why isoutcry associated with the failure of Enron comes from thethe failure of Enron so important? After all, failure is justfact that this failure provides a clear warning as to just whatevidence of the Darwinian survival of the fittest principlecan happen. Investor confidence in the system of publicat work, right? However, the Enron situation seems to be reporting has been shaken. If the most innovative companydifferent. Lets consider some of the reasons why thein America for six straight years and the darling of WallEnron case might be special and see if they can explainSrreet can be this close to bankruptcy and no one seems tothe public rancor over the firms failure. notice, what about less notable firms?This Was the Largest Bankruptcy Ever"Political Influence, Fraud, and ScandalTrue, Enrons bankruptcy is the largest such bankruptcy ever Even the National Enquirer devoted its cover story towith a total of $63 billion in equity value vaporized in a Enron. b Add the prospect of criminal wrongdoing by12-month period. But this loss of shareholder value is far Enrons executives to the fact that Enron was a major confrom the largest such loss of value ever. Consider the facttributor to both political parties (although its ties to thethat the following list of firms have lost more than twice the Republican party are better known) and you have the stuff ofshareholder value that Enron lost: AOL Time Warner,which good soap opera plots are made.Cisco, EMC, Intel, JDS Uniphase, Lucent, Microsoft,Nortel, Sun Microsystems, and Worldcom. In fact, the value "From "More Reasons ro Get Riled Up," Geoffrey Colvin, Fortllne (3/4/02).of Ciscos equity fell a mind boggling $423 billion compared 2002 Time, Inc. All Rights Reserved.to Enrons meager $63 billion. But since Enron lost every bKevin Lynch, Michael Hanrahan, and David Wrighr, "Enron: The Untoldthing, thats different, right? Global Crossings also lost Srory," The NlTtirmal Enqllirer (February 26,2002). our decision should have on the stock price if everything else were held constant. The market price Of the firms stock reflects the value of the firm as seen by its owners and takes into account the complexities and complications of the real-world risk. As we follow this goal throughout our discussions, we must keep in mind that the shareholders are the legal owners of the firm. See the Finance Matters box, "Ethics: The Enron Lessons."CONCEPT CHECK1. What are the problems with the goal of profit maximization? !2. What is the goal of the firm? I - - 16. CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 7 LEGAL FORMS OF BUSINESS ORGANIZATtONObjective-.!JIn the chapters ahead, we will focus on financial decisions for corporations. Although thecorporation is not the only legal form of business available, it is the most logical choicefor a firm that is large or growing. It is also the dominant business form in terms of salesin this country. In this section, we will explain why this is so. This will in turn allow us tosimplify the remainder of the text, as we will assume that the proper tax code to follow isthe corporate tax code, rather than examine different tax codes for different legal forms ofbusinesses. Keep in mind that our primary purpose is to develop an understanding of thelogic of financial decision making. Taxes will become important only when they affect ourdecisions, and our discussion of the choice of the legal form of the business is directed atunderstanding why we will limit our discussion of taxes to the corporate form.Legal forms of business organization are diverse and numerous. However, there arethree categories: the sole proprietorship, the partnership, and the corporation. Tounderstand the basic differences between each form, we need to define each form andunderstand its advantages and disadvantages. As we will see, as the firm grows, theadvantages of the corporation begin to dominate. As a result, most large firms take onthe corporate form.SOLE PROPRIETORSHIPThe sole proprietorship is a business owned by a single individual. The owner main-Sole proprietorshiptains title to the assets and is personally responsible, generally without limitation, for the t:- business owned by a singleliabilities incurred. The proprietor is entitled to the profits from the business but mustindiVIdual.also absorb any losses. This form of business is initiated by the mere act of beginning the (I:---;Tl e +~,1::"-~:" o D,;business operations. Typically, no legal requirement must be met in starting the opera- .,c. - ,_ . ,~,tion, particularly if the proprietor is conducting the business in his or her own name. If as. -n~ ,_ ~l ""special name is used, an assumed-name certificate should be filed, requiring a small regis- ,_ - rtration fee. Termination occurs on the owners death or by the owners choice. Briefly u:, "t.;)]I.Ii J ;"1stated, the sole proprietorship is, for all practical purposes, the absence of any formal!ega!business structure.PARTNERSHIPThe primary difference between a partnership and a sole proprietorship is that the part Partnershipnership has more than one owner. A partnership is an association of two or more personsAn association of two or morecoming together as co-owners for the purpose of operating a business for profit. individuals joining together as co-owners to operate a businessPartnerships fall into two types: (1) general partnerships and (2) limited partnerships. for profit.GENE RAL PA RTNERSHIP In a general partnership, each partner is fully responsiblefor the liabilities incurred by the parmership. Thus, any parmers faulty conduct evenhaving the appearance of relating to the firms business renders the remaining partnersliable as well. The relationship among parmers is dictated entirely by the partnershipagreement, which may be an oral commitJnent or a formal document.LIMITED PARTNERSHIP AND LIMITED LIABILITY COMPANY Inadditiontothe general partnership, in which all partners are jointly liable without limitation, manystates provide for a limited partnership. The state statutes permit one or more of the partners to have limited liability, restricted to the amount of capital invested in the partnership. Several conditions must be met to qualify as a limited parmer. First, at least onegeneral partner must remain in the association for whom the privilege of limited liabilitydoes not apply. Second, the names of the limited partners may not appear in the name of j 17. 8PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT the firm. Third, the limited partners may not participate in the management of the busi ness. If one of these restrictions is violated, all partners forfeit their right to limited liabil ity. In essence, the intent of the statutes creating the limited partnership is to provide lim ited liability for a person whose interest in the partnership is purely as an investor. That individual may not assume a management function within the organization.Limited liability companyA limited liability company (LLC) is a cross between a partnership and a corpora(LLC)tion. It retains limited liability for its owners, but is run and taxed like a partnership. BothAn organizational form that is a states and the IRS have rules for what qualifies as an LLC, but the bottom line is that itcross between a partnershipand a corporation. must not look too much like a corporation or it will be taxed as one. CORPORATIONCorporationThe corporation has been a significant factor in the economic development of theAn entity that legally functions United States. As early as 1819, ChiefJustice John Marshall set forth the legal definitionseparate and apart from itsof a corporation as "an artificial being, invisible, intangible, and existing only in the conowners. templation of law."2 This entity legally functions separate and apart from its owners. As such, the corporation can individually sue and be sued, and purchase, sell, or own prop erty; and its personnel are subject to criminal punishment for crimes. However, despite this legal separation, the corporation is composed of owners who dictate its direction and policies. The owners elect a board of directors, whose members in turn select individuals to serve as corporate officers, including president, vice president, secretary, and treasurer. Ownership is reflected in common stock certificates, designating the number of shares owned by its holder. The number of shares owned relative to the total number of shares outstanding determines the stockholders proportionate ownership in the business. Because the shares are transferable, ownership in a corporation may be changed by a shareholder simply remitting the shares to a new shareholder. The investors liability is confined to the amount of the investment in the company, thereby preventing creditors from confiscating stockholders personal assets in settlement of unresolved claims. This is an extremely important advantage of a corporation. After all, would you be willing to invest in General Electric if you would be liable in the event that one of their airplane engines malfunctions and people die in a crash? Finally, the life of a corporation is not dependent on the status of the investors. The death or withdrawal of an investor does not affect the continuity of the corporation. The management continues to run the corpora tion when stock is sold or when it is passed on through inheritance. See the Finance Matters box, "Ethics: The Enron Lessons." COMPARISON OF ORGANIZATIONAL FORMS Owners of new businesses have some important decisions to make in choosing an organi zational form. Whereas each business form seems to have some advantages over the oth ers, we will see that, as the firm grows and needs access to the capital markets to raise funds, the advantages of the corporation begin to dominate.Large and growing firms choose the corporate form for one re~son: ease in raising capital. Because of the limited liability, the ease of transferring ownership through the sale of common shares, and the flexibility in dividing the shares, the corporation is the ideal business entity in terms of attracting new capital. In contrast, the unlimited liabili: ties of the sole proprietorship and the general partnership are deterrents to raising equity capital. Between the extremes, the limited partnership does provide limited liability for limited partners, which has a tendency to attract wealthy investors. However, the imprac 1 Tbe Trustees ofDmtmrJUtb College v. Woodward, 4 Wheaton 636 (1819). 18. CHAPTERAN INTRODUCTION TO FINANCIAL MANAGEMENT9 THE ENRON LESSONSThe bankruptcy and failure of the Enron Corporation onlead to a type of managerial short-sightedness or myopiaDecember 2, 2001 shook the investment community tothat focuses managerial attention on "hyping" the firmsits very core and resulted in congressional hearings that potential to investors in an effort to reach higher market val-could lead to new regulations with far reaching implica-uations of the firms stock.tions. Enrons failure provides a sober warning toFrom the shareholders perspective one might ask what isemployees and investors and a valuable set of lessons for wrong with achieving a higher stock price? The problem isstudents of business. The lessons we offer below reach farthat this can lead to a situation where investor expectationsbeyond corporate finance and touch on fundamental become detached from what is feasible for the firm.principles that have always been true, but that are some- Ultimately, when investors realize that the valuation of thetimes forgotten.firms shares is unwarranted, there is a day of reckoning thatcan bring catastrophic consequences as it did with Enron.Lesson: Maximizing Share Value Is Not AlwaysThus, maximizing share value where the firms underlyingthe BeSt Thing to Dofundamentals do not support such valuations is dangerousIf there is a disconnect between current market prices andbusiness. In fact, it is not clear which is worse, having anthe intrinsic worth of a firm then attempts to manipulate over- or an undervalued stock price.share value may appear to be possible over the short run. The problems associated with ma.naging for shareholderUnder these circumstances problems can arise if firms use value in a capital market that is less than omniscient (per-equity-based compensation based on performance bench- fectly efficient) is largely uncharted territOly for financialmarks using stock price or returns. These circumstances can economists.ticality of having a large number of partners and the restricted marketability of an inter-est in a partnership prevent this form of organization from competing effectively with thecorporation. Therefore, when developing our decision models, we will assume that weare dealing with the corporate form. The taxes incorporated in these models will dealonly with the corporate tax codes. Because our goal is to develop an understanding of themanagement, measurement, and creation of wealth, and not to become tax experts, in thefollowing chapter we will only focus on those characteristics of the corporate tax codethat will affect our financial decisions.THE ROLE OF THE FINANCIAL MANAGERIN A CORPORATIONAlthough a firm can assume many different organizational structures, Figure 1-1 presentsa typical representation of how the finance area fits into a corporation. The VicePresident for Finance, also called the Chief Financial OffIcer (CFO), serves under thecorporations Chief Executive Officer (CEO) and is responsible for overseeing financialplanning, corporate strategic planning, and controlling the firms cash flow. Typically, aTreasurer and Controller serve under the CFO. In a smaller firm, the same person mayfill both roles, with just one office handling all the du.ties. The Treasurer generally han-dles the firms financial activities, including cash and credit management, making capitalexpenditure decisions, raising funds, financial planning, and managing any foreign cur-rency received by the firm. The Controller is responsible for managing the firmsaccounting duties, including producing financial swtements, cost accounting, payingtaxes, and gathering and monitoring the data necessary to oversee the firms financialwell-being. In this class, we focus on the duties generally associated with the Treasurerand on how investment decisions are made. 19. 10 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENTFIGURE 1-1 How the Finance Area Fits into a Corporation Board of Directors Chief Executive Officer (CEO) ::=JVice President-Vice President-Finance Vice President- MarketingorProduction and Operations ChiefFinanciaI Officer (CFO) Duties: Oversee financial planning Corporate strategic planning Control corporate cash flowTreasurerController Duties: Duties: Cash management Taxes Credit management Financial statements Capital expendituresCost accounting Raising capital Data processing Financial planning Management of foreign currencies CONCEPT CHECK 1. What are the primary differences among a sole proprietorship, apartnership, and a corporation? 2. Explain why large and growing firms tend to choose the corporateIform. 3. What are the duties of the Corporate Treasurer? Of the CorporateController? I -- - -"--" - -- THE CORPORATION AND THE FINANCIAL MARKETS: THE INTERACTION Without question, the ease of raising capital is the major reason for the popularity of the corporate form. While we will look at the process of raising capital in some detail in Chapter 14, lets spend a moment looking at the flow of capital through the financial mar- kets among the corporation, individuals, and the government.Figure 1-2 examines these flows. (1) Initially, the corporation raises funds in the finan- cial markets by selling securities. The corporation receives cash in return for securities- stocks and debt. (2) The corporation then invests this cash in return-generating assets- new projects for example-and (3) the cash flow from those assets is then either reinvested 20. CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT11FIGURE 1-2 The Corporation and the Financial Markets: The Interaction1. Initially, the corporation raises funds in the financial markets by selling securities-stocks and bonds; 2. Thecorporation then invests this cash in return-generating assets-new project; 3. The cash flow from those assets is eitherreinvested in the corporation, given back to the investors, or paid to the government in the form of taxes.1.Primary Markets Corporation CashInvestorsSecondaty marketsoSecurities 2.CorporationCash reinvestedinvests in the corporationin return-Securities tradedgenerating 3. among investors assetsCash flow fromCash distributed operationsback to investorsTaxes (rl)vernmentin the corporation; given back to the investors in the form of dividends or interest pay-ments, or used to repurchase stock, which should cause the stock price to rise; or given tothe government in the form of tax payments.One distinction that is important to understand is the difference between primaryand secondary markets. Again, we will reexamine raising capital and the differencebetween primary and secondary markets in some detail in Chapter 14. To begin with, asecurities market is simply a place where you can buy or sell securities. These markets cantake the form of anything from an actual building on Wall Street in New York City to anelectronic hookup among security dealers all over the world. Securities markets aredivided into primary and secondary markets. Lets take a look at what these terms mean. A primary market is a market in which new, as opposed to previously issued, securi- Primary marketties are traded. This is the only time that the issuing firm actually receives money for it~ A market in which new, as opposed to previously issued,stock. For example, if Nike issues a new batch of stock, this issue would be considered a securities are traded.primary market transaction. In this case, Nike would issue new shares of stock and receive Initial public offering (lPO)money from investors. Actually, there are two different types of {)fferings in the primary The first time the companysmarkets: initial public offerings and seasoned new issues or primary offerings. An initial stock is sold to the public.public offering (IPO) is the first time the companys stock is sold to the general public, Seasoned new issuewhereas a seasoned new issue refers to stock offerings by companies that already haveStock offerings by companiescommon stock traded in the secondary market. Once the newly issued stock is in the pub-that already have commonlics hands, it then begins trading in the secondary market. Securities that have previ- stock traded.ously been issued and bought are traded in the secondary market. For example, if you Secondary marketbought 100 shares of stock in an IPO and then wanted to resell them, you would beThe market in which stock previously issued by the firmreselling them in the secondary markets. The proceeds from the sale of a share of IBMtrades.stock in the secondary market go to the previous owner of the stock, not to IBM. That isbecause the only time IBM ever receives money from the sale of one of its securities is inthe primary markets. 21. 12PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT AN INTERVIEW WITH JEFF BlEUSTEIN. HARlEY-DAVIDSONS CEO Jeff Bleustein is the Chief Executive Officer at Harley- much-needed capital to support our operations while we Davidson Company, Inc. In our interview with Mr. Bleustein,paid on the firms large amounts of debt. he highlighted a number of milestones that he believes have In 1983, we established our Harley Owners Group greatly influenced the companys success over the past two (HOG) to encourage our customers to use their bikes decades. Much of what he had to say related directly to theand stay illYolved with the company. At the end of 2000, main topics of this book. Specifically, he talked about thewe had nearly 600,000 members. We also began a pro- companys strategies in the areas of investment decisions, gram of carefully managing the licensing of the Harley- working-capital management, financing decisions, marketing Davidson name. strategies, and global expansion. He also emphasized the In the 1980s, we began a program to empower our importance of the people who implement these decisions. He employees. We needed to let everyone in the organization insists that there is more to business than crunching the num- know what was expected of him or her, which led us to the bers; it is people that make the difference. Mr. Bleusteins development of our corporate vision and statement ofval- remarks can be summarized as follows:ues! I strongly believe that the only sustainable corporateadvantage a company can have is its people. In 1981, the management of Harley-Davidson bought In 1994, we began fostering a partnership with our the company from its parent company, ANIF, in a lever-unions to enable them to participate fully in the business. aged buyout. The extremely high level of debt incurredToday our two unions participate fully with the firms to finance the purchase placed the company in a very frailmanagement in a wide range of decision making, includ- financial condition. The downturn in the economy, com-ing the firms strategies. bined with the debt load, created a powerful incentive to Ve also initiated our circle organization, which involves improve operations to conserve cash. To add to the prob-the use of a team structure at our vice president level of lems, the firms principal lender, Citibank, announced inmanagement to make the decisions. As a result, we elim- 1985 that it wanted out of its creditor position for theinated a whole layer from top management. firm. Last-minute refinancing was arranged on Beginning in the 19905, we entered into a serious effort to December 31, 1985 to save the company from bank-globalize the company. We established a management team ruptcy. Then, within a few short months the companysin Europe, and over time we acquired our independent dis- financial picture had improved to the point where wetributors in major market~, such as the BenelufX, and Italy. were able to take the company public in an initial public offering.All of these decisions have significant financial implications During the past two decades, the company has made sig- that are tied to our study of finance. Specifically, they reflect nificant capital investments in new product lines, such as financing choices, investment decisions, and working- the Evolution engine, the Softail motorcycle, and most capital management. So, we invite you to join us in our study recently, the Twin Cam 88 engine, one of our current of finance and, in the process, learn about a company that engine designs. Also, in 1998 we invested in new manu- has accomplished in real terms what few others have been facturing facilities in Kansas City, Missouri, and able to eLl. Menominee Falls, Wisconsin. To improve the films management of its working capital, Harley-D;lvidson Motor Company: mission statement is, ""Ve fulfill we introduced the use of just-in-time inventory conuol. dreams through the experiences of motorcycling by providing to motorcy-clists and the general public an expanding line of motorcycles, branded We called our program MAN, which stands for Materialsproducts and services in selected market segments. The firms value state- As Needed. This program allowed us to remove $51 mil-ment is exprcssed as, Tell the tmth, be fair, keep your promises, respect the lion from our work-in-process inventory and provided individual, and encourage intellectual curiosity.Objective --.!J TEN PRINCIPLES THAT FORM THE BASICSOF FINANCIAL MANAGEMENTWe will now look at the finance fow1dations that lie behind the decisions made by finan-cial managers. To the first-time student of finance, the subject matter may seem like a col-lection of unrelated decision rules. This could not be further from the truth. In fact, our 22. CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 13decision rules, and the logic that underlies them, spring from 10 simple principles that donot require knowledge of finance to understand. However, while it is not necessary to under-standfinance in order to understand these priluiples, it is necessary to understand these principlesin order to understand finance. Keep in mind that although these principles may at firstappear 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 manage-ment. In order to make the learning process easier for you as a student, we will keepreturning 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." PRINCIPLEThe Risk-Return Trade-Oft-We wont take on additionalrisk unless we expect to be compensated with additionalreturnAt some point, we have all saved some money. Why have we done this? The answer issimple: to expand our future conswnption opportunities-for example, save for a house,a car, or retirement. We are able to invest those savings and earn a return on our dollarsbecause some people would rather forgo future consumption opportunities to consumemore now-maybe theyre borrowing money to open a new business or a company isborrowing money to build a new plant. Assuming there are a lot of different people thatwould like to use our savings, how do we decide where to put our money?First, investors demand a minimum return for delaying conswnption that must begreater than the anticipated rate of inflation. If they didnt receive enough to compensatefor anticipated inflation, investors would purchase whatever goods they desired ahead oftime or invest in assets that were subject to inflation and earn the rate of inflation onthose assets. There isnt much incentive to postpone conswnption if your savings aregoing 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 theseinvestments offer higher expected returns. The more risk an investment has, the higherwill be its expected return. This relationship between risk and expected return is shownin Figure 1-3. FIGURE 1-3The Risk-Return RelationshipEa~-gtExpected return :.I .~~, .. . , , ~. THE WALL STREET JOURNAL WORKPLACE-ETHICS QUIZ Without question, when you enter the workforce you will be8. Can you accept a $75 prize won at a raffle at a suppliers faced with a number of ethical dilemmas that you have neverconference? considered. The spread of technology into the workplaceYes No has raised a variety of new ethical questions, and many old ones still linger. The following is a quiz dealing with ethical Truth and Lies questions that will both give you some questions to think9. Due to on-the-job pressure, have you ever abused or about, and also allow you to compare your answers withlied about sick days? those of other Americans surveyed.Yes No 10. Due to on-the-job pressure, have you ever taken credit for someone elses work or idea? Office Technology Yes No1. Is it wrong to use company e-mail for personal reasons? Yes No Ethics-Quiz Answers2. Is it wrong to play computer games on office equipment1. 34% said personal e-mail on company computers is during the workday? wrong Yes No2. 49% said playing computer games at work is wrong3. Is it unethical to blame an error you made on a techno-3. 61 % said its unethical to blame your error on technology logical glitch?4. 35% said a $50 gift to the boss is unacceptable Yes No5. 12% said a $50 gift from the boss is unacceptable6. 70% said its unacceptable to take the $200 football tickets Gifts and Entertainment7. 35% said its unacceptable to take the $100 food basket4. Is a $50 gift to a boss unacceptable?8. 40% said its unacceptable to take the $75 raffle prize Yes No 9. 11 % reponed they lie about sick days5. Is a $50 gift from the boss unacceptable? 10. 4% reported they take credit for the work or ideas of Yes Noothers6. Of gifts from suppliers: Is it OK to take a $200 pair of football tickets?Sources: Ethics Officer Association, Belmont, Mass.; Ethical LeadershipGroup, Vlilmette, Ill.; surveys sampled a cross-section of workers at large Yes Nocompanies and natiom~de; Reprinted by permission of The U7a1J St/eet7. Is it OK to take a $100 holiday food basket?J01l17101, Copyright 1999 Dow Jones & Company, Inc. All Rights Yes NoReserved Worldwide. License number 880500341261. CONCEPT CHECK 1. According to Principle 1, how do investors decide where to invest theirmoney? 2. Why is it so hard to find extremely profitable projects?I 3. Why is ethics relevant?OVERVIEW OF THE TEXT In this text, we will focus on the maintenance and creation of wealth. Although this will involve attention to decision-making techniques, we will emphasize the logic behind those techniques to ensure that you do not lose sight of the concepts driving finance and the creation of wealth. The text begins by discussing the goal of maximization of share- holder wealth, a goal that is to be used in financial decision making, and presents the legal 32. CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT 23 AN ENTREPRENEURS~", , . ..7- P - T I .~ ::.tot. ~~ THE ENTREPRENEUR AND FINANCE Do you ever think about wanting to someday own your ownphysical-that must be available. The entrepreneur usu- business? Does being an entrepreneur have any appeal toally does not have the capital to own all the resources you? Well, it does for a lot of people. During the pastthat are needed. So she must have access to resources, decade, starting and growing companies have been the pre-but usually cannot afford to own them. Its what we call ferred avenue many have chosen for careers. In fact, while bootstrapping. The goal is to do more with less. many of the large companies are reducing the number of Launch the venture. All the planning in the world is not employees, smaller companies are creating new jobs by theenough. The entrepreneur must be action oriented. It thousands. A lot of individuals have thought that there wasrequires a "can do" spirit. greater security in working with a big company, only to be Grow the business. A business has to grow if it is to be disillusioned in the end when they were informed thatsuccessful. Frequently, the firm will not break even for "Friday is your last day." several years, which means that we will be burning up Defining an entrepreneur is not an easy thing to do. But cash each month. Being able to survive during the time we can say with some clarity what entrep"meul"Ship is about. that cash flows are negative is no easy task. If we grow too Entreprenewship has been defined as a relentless pursuit of slow, we lose, but also if we grow too fast, we may lose as opportunity for the purpose of creating value, without con-well. During this time, additional capital will be needed, cern for the resources owned. .which requires that we know how to value the firm and10 be successful, the entrepreneurial process requireshow to structure financing. that the entrepreneur be able to: Exit the business. If a venture has been successful, theentrepreneur will have created economic value that is Identify a good opportunity. Oftentimes we may have alocked up in the business. At some point in time, the "good idea," but it may not be a "good opportunity."entrepreneur will want to capture the value that has been Opportunities are market driven. There must becreated by the business. It will be time to harvest. enough customers who want to buy our product or service at a price that covers our expenses and leaves To be successful as an entrepreneur requires an understand- an attractive profit-no matter how much we may likeing of finance. At the appropriate places in Financial the idea.Management, we will be presenting how finance relates to Gain access to the resources needed. For any venture,the entrepreneurial journey. It is an interesting topic that we there are critical resources-human, financial, and think you will enjoy.and tax environment in which these decisions are to be made. Since this environment setsthe ground rules, it is necessary to understand it before decision rules can be formulated.The 10 guiding principles that provide the underpinnings for what is to follow are thenpresented. Chapters 2 through 4 introduce the basic financial tools the financial manageruses to maintain control over the firm and its operations. These tools enable the financialmanager to locate potential problem areas and plan for the future.Chapter 5 explores how the firm and its assets are valued. It begins with an examina-tion of the mathematics of finance and the concept of the time value of money. An under-r standing of this topic allows us to compare benefits and costs that occur in different timeperiods. We move on in Chapter 6 to develop an understanding of the meaning and mea-surement of risk. Valuation of fixed income securities is examined in Chapter 7, andChapter 8 looks at valuation models that attempt to explain how different financial deci-sions affect the firms stock price.Using the valuation principles just developed, Chapter 9 discusses the capital-budgeting decision, which involves the financial evaluation of investment proposals infixed assets. We then examine the measurement of cash flows in Chapter 10, andintro-duce methods to incorporate risk in the analysis in Chapter 11. In Chapter 12, we willexamine the financing of a firms chosen projects, looking at what costs are associated 33. 24 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT with alternative ways of raising new funds. Then, in Chapter 13, we look at managing the finn for shareholder value. Chapter 14 examines the financial markets and the act of raising funds. Chapter 15 examines the fums capital structure along with the impact of leverage on returns to the enterprise. Once these relationships between leverage and valuation are developed, we move on to the process of planning the firms financing mix in Chapter 16. This is fol- lowed in Chapter 17 with a discussion of the determination of the dividend-retained earnings decision. Chapters 18 through 20 deal with working-capital management, the management of current assets. We will discuss methods for determining the appropriate investment in cash, marketable securities, inventory, and accounts receivable, as well as the risks associ- ated with these investments and the control of these risks. Chapter 21 presents discussion of the use of futures, options, and swaps by financial managers to reduce risk. The final chapter in the text, Chapter 22, deals with interna- tional financial management, focusing on how financial decisions are affected by the international environment. In addition, Chapter 23, an introduction to corporate restruc- turing including mergers, spinoffs, and leveraged buyouts, is provided on the Internet. Similarly, Chapter 24, Loans and Leases, is also provided on the Internet. Objective ~FINANCE AND THE MULTINATIONAL FIRM:THE NEW ROLE In the search for profits, U.S. corporations have been forced to look beyond our countrys borders. This movement has been spurred on by the collapse of conununism and the acceptance of the free market system in Third World countries. All of this has taken place at a time when information technology has experienced a revolution brought on by the personal computer (PC). Concurrently, the United States went through an unprece- dented period of deregulation of industries. These changes resulted in the opening of new international markets, and U.S. firms experienced a period of price competition here at home that made it imperative that businesses look across borders for investment opportunities. The end result is that many U.S. companies, including General Electric, IBM, Walt Disney, American Express, and General Motors, have restructured their oper- ations in order to expand internationally. However, not only do U.S. firms have a freer access to international markets, but also foreign firms have an easier job of entering the U.S. markets and competing with U.S. firms on their own turf.The bottom line is that what you think of as a U.S. firm may be much more of a multinational firm than you would expect. For example, Coca-Cola earns over 80 per- cent of its profits from overseas sales. Moreover, Coca-Cola earns more money from its sales in Japan than it does from all its domestic sales, and this is not uncommon. In fact, Dow Chemical, Colgate-Palmolive, 3M, Compaq, Hewlett-Packard, and Gillette make over half their sales overseas and earn over half of their profits from interna- tional sales. In addition to U.S. firms venturing abroad, foreign firms have also made their mark in the United States. You need only look to the auto industry to see what changes the entrance of Toyota, Honda, Nissan, BMW, and other foreign car manu- facturers have made in the auto industry. In addition, foreigners have bought and now own such companies as Brooks Brothers, RCA, Pillsbury, A&P, 20th Century Fox, Columbia Pictures, and Firestone Tire & Rubber. Consequently, even if we wanted to, we couldnt keep all our"attention focused on the United States, and even more impor- tant, we wouldnt want to ignore the opportunities that are available across interna- tional borders. 34. CHAPTER AN INTRODUCTION TO FINANCIAL MANAGEMENT 25 CONCEPT CHECK 1. What has brought on the era of the multinational corporation? 2. Has looking beyond U.s. borders been a profitable experience for U.s.corporations? HOW FINANCIAL MANAGERS USE THIS MATERIALAs the chapter title states, this chapter provides you with an introduction to financialmanagement. The principles presented in this chapter provide you with some clues as tothe types of questions that will be dealt with by financial managers. As you will find outover the course of your studies, financial questions abound. In the Spring of 2003, head-lines in The Willi Street Journal were full of financial decisions, including the giant drugmakers Pfizer and Pharmacia winning final approval for their merger, Disney nearing adeal to sell its Anaheim Angels baseball team for $160 to $180 million, and AOL TimeWarner Inc. reporting a 2002 net loss of$98.7 billion after taking a fourth-quarter chargeof $45.5 billion, mostly to write down the value of its troubled America Online unit whileit tried to sell its Atlanta-based teams-baseballs Atlanta Braves, basketballs AtlantaHawks, and hockeys Atlanta Thrashers. But financial questions and decisions alsoappeared in the headlines in the sports section when the Washington Redskins signedLavernues Coles to a $35 million contract and basketball coach Ben Howland took theUCLA coaching job at a salary of $900,000 per year. hat do all of these financial decisions have in common? They are all based on the10 principles presented in this chapter, and they all deal with decision making. They areall financial decisions, because the focus of finance is how to raise and spend or investmoney. Your goal as a financial manager is to manage the firm in such a way that share-holder wealth is maximized. As you will see, there are few, if any, major decisions that amanager makes that dont have financial implications.[[IIThis chapter outlines a framework for the maintenance and creation of wealth. In introducing 0 b j e c t i ve1 Idecision-making techniques aimed at creating weal til, we will emphasize the logic behind those~techniques. This chapter begins with an examination of the goal of the firm. The commonlyaccepted goal of profit maximization is contrasted with the more complete goal of maximization 0bj e c t I ve2 Iof shareholder wealth. Because it deals well with uncertainty and time in a real-world environ-~ment, the goal of maximization of shareholder wealtll is found to be the proper goal for the firm.The sole proprietorship is a business operation owned and managed by a single individual.0 b j e c t; ve 3 IInitiating this form of business is Simple and generally does not involve any substantial organiza-~tional costs. The proprietor has complete control of the firm, but must be willing to assume fullresponsibility for its outcomes.The general partnership, which is simply a coming together of two or more individuals, issimilar to the sole proprietorship. The limitea partnership is another form of partnership sanc-tioned by states to permit all but one of the partners to have limited liability if this is agreeable toall partners.The corporation increases the flow of capital from public investors to the business commu-nity. Although larger organizational costs and regulations are imposed on this legal entity, thecorporation is more conducive to raising large amount, of capital. Limited liability, continuity oflife, and ease of transfer in ownership, which increase the marketability of the investment, havecontributed greatly in attracting large numbers of investors to the corporate environment. The 35. 26 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENTformal control of the corporation is vested in the parties who own the greatest number of shares.However, day-to-day operations are managed by the corporate officers, who theoretically serveon behalf of the COIlUTIon stockholders. Objective ~This chapter closes with an examination of the 10 principles on which finance is built thatmotivate the techniques and tools introduced in this text: PRINCIPLEThe Risk-Return Trade-Oft-We wont take on additionalrisk unless we expect to be compensated with additionalreturn PRINCIPLE2 The Time Value of Money-A dollar received today is worthmore than a dollar received in the future PRINCIPLE 3Cash-Not Profits-Is King PRINCIPLEIncremental Cash Flows-Its only what changes thatcounts PRINCIPLEThe Curse of Competitive Markets-Why its hard to findexceptionally profitable projects PRINCIPLE 6Efficient Capital Markets-The markets are quick and theprices are right PRINCIPLEThe Agency Problem-Managers wont work for ownersunless its in their best interest PRINCIPLE 8 Taxes Bias Business Decisions PRINCIPLE 9All Risk Is Not Equal-Some risk can be diversified away,and some cannot PRINCIPLEEthical behavior is doing the right thing, and ethicaldilemmas are everywhere in finance Objective ~With the collapse of communism and the acceptance of the free market system in Third Worldcountries, U.S. firms have been spurred on to look beyond our own boundaries for new business.The end result has been that it is not uncommon for major U.S. companies to earn over halftheir income from sales abroad.Agency problem, 17 Limited liabilitySeasoned new issue, 11Go To:Corporation, 8company (LLC), 8Secondary market, 11www.prenhall.comlkeown Partnership, 7Efficient market, 16Sole proprietorship, 7for downloads and currentevents associated with this lllitialpublicoffering Primary market, 11chapter (lPO),11 36. CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT21STUDY QUESTIONS1-1. What are some of the problems involved in the use of profit maximization as the goal of thefinn? How does the goal of maximization of shareholder wealth deal with those problems?, 1-2. Compare and contrast the goals of profit maximization and maximization of shareholderwealth.1-3. Finns often involve themselves in projects that do not result direccly in profits; for example,IBM and Mobil Oil frequently support public television broadcasts. Do these projects contradictthe goal of maximization of shareholder wealth? Why or why not?1-4. What is the relationship between financial decision making and risk and return? Would allfinancial managers view risk-return trade-offs similarly?1-5. Define (a) sole proprietorship, (b) partnership, and (c) corporation.1-6. Identify the primary characteristics of each fonn of legal organization.1-7. Using the following criterl~; specify the legal form of business that is favored: (a) organiza-tional requirements and costs, (b) liability of the owners, (c) continuity of business, (d) transfer-ability of ownership, (e) management control and regulations, (f) ability to raise capital, and(g) income taxes. I NTEGRAT I. VEP ROB L EMIThe final.stage in the interview process for an Assistant Financial Analyst at Caledonia Productsinvolves a test of your understanding of basic financial concepts. You are given the followingmemorandum and asked to respond to the questions. Whether or not you are offered a positionat Caledonia will depend on the accuracy of your response.To: Applicants for the position of Financial AnalystFrom: Mr. V Morrison, CEO, Caledonia ProductsRe: A test of your understanding of basic financial concepts and of the Corporate Tax CodePlease respond to the following questions: 1. What are the differences between the goals of profit maximization and maximization ofshareholder wealth? Which goal do you think is more appropriate? 2. What does the risk-return trade-off mean? 3. Why are we interested in cash flows rather than accounting profits in determining the valueof an asset? 4. What is an efficient market and what are the implications of efficient markets for us? 5. What is the cause of the agency problem and how do we try to solve it? 6. What do ethics and ethical behavior have to do with finance? 7. Define (a) sole proprietorship, (b) partnership, and (c) corporation. ; CAS EPOL E j" ~.~_ - ~., ...- ~.6". 1"ETHie SLIVING AND DYING WITH ASBESTOS accepted and when they should be tenninated. As new infor-What happens when you find your most profitable product is mation surfaces regarding the future profitability of a project,dangerous-an ethical dilemma for the financial manager.the firm always has the choice of terminating that project. When this new infonnation raises the question of whether orMuch of what we deal with in financial management centersnot it is ethical to produce a profitable project, the decisionaround the evaluation of projects-when they should bebecomes more difficult. Many times, ethical dilemmas pit 37. 28 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENTprofits versus ethics. These decisions become even more diffi-any question about the arbiter of publication, Brown wrote tocult when continuing to produce the product is within the law.officials at the laboratory conducting the tests: Asbestos is a fibrous mineral used for fireproofing, electri- It is our further understanding that the results obtained will becal insulation, building materials, brake linings, and chemicalconsidered the property of those who are advancing thefilters. If you are exposed long enough to asbestos particles- required funds, who will determine whether, to what extentusually 10 or more years-you can develop a chronic lungand in what manner they shall be made public. In the event it isinflammation called asbestosis, which makes breathing diffi- deemed desirable that the results be made public, the manu-cult and infection easy. Also linked to asbestos exposure is script of your srudy will be submitted to us for approval priormesetheJioma, a cancer of the chest lining. This disease some- to publication.times doesnt develop until 40 years after the first exposure. Industry officials were concerned with more than control-Although the first major scientific conference on the dangers ling information flow. They also sought to deny workers earlyof asbestos was not held until 1964, the asbestos industry knew evidence of their asbestosis. Dr. Kenneth Smith, medicalof the dangers of asbestos 60 years ago.director of a Johns-Manville plant in Canada, explained why As early as 1932, the British documented the occupationalseven workers he found to have asbestosis should not behazards of asbestos dust inhalation." Indeed, on September 25,informed of their disease:1935, the editors of the trade journal Asbestos wrote to SumnerSimpson, president of Raybestos-Manhattan, a leading It must be remembered that although these men have the X-ray evidence of asbestosis, they are working today and defi-asbestos company, asking permission to publish an article on nitely are not disabled from asbestosis. They have not beenthe dangers of asbestos. Simpson refused and later praised the told of this diagnosis, for it is felt that as long as the man feelsmagazine for not printing the article. In a letter to Vandivar well, is happy at home and at work, and his physical conditionBrown, secretary of Johns-Manville, another asbestos manu- remains good, nothing should be said. When he becomes dis-facrurer, Simpson observed: "The less said about asbestos theabled and sick, then the diagnosis should be made and thebetter off we are." Brown agreed, adding that any article on claim submitted by the Company. The fibrosis of this disease isasbestosis should reflect American, not English, data. irreversible and permanent so that evenrually compensation In fact, American data were available, and Brown, as one of will be paid to each of these men. But as long as the man is notthe editors of the journal, knew it. Working on behalf ofdisabled, it is felt that he should not be told of his condition soRaybestos-Manhattan and Johns-Manville and their insurance that he can live and work in peace and the Company can bene- fit by his many years of experience. Should the man be told ofcarrier, Metropolitan Life Insurance Company, Anthony Lanza his condition today there is a very definite possibility that hehad conducted research between 1929 and 1931 on 126 workerswould become mentally and physically ill, simply through thewith 3 or more years of asbestos exposure. But Brown and oth-knowledge that he has asbestosis.ers were not pleased with the paper Lanza submitted to themfor editorial review. Lanza, said Brown, had failed to portray Vhen lawsuits filed by asbestos workers who had devel-asbestosis as milder than silicosis, a lung disease caused by long- oped cancer reached the industIy in the 1950s, Dr. Smith sug-term inhalation of silica dust and resulting in chronic shortness gested that the industry retain the Industrial Health Foundationof breath. Under the then-pending Workmens Compensationto conduct a cancer srudy that would, in effect, squelch theJaw, silicosis was categorized as a compensable disease. If asbestos-cancer connection. The asbestos companies refused,asbestosis was worse than silicosis or indistinguishable from it, claiming that such a srudy would only bring further unfavorablethen it too would have to be covered. Apparently Brown didnt publicity to the industry, and that there wasnt enough evidencewant this and thus requested that Lanza depict asbestosis as less linking asbestos and cancer industry-wide to warrant it.serious than silicosis. Lanza complied and also omitted from his Shortly before his death in 1977, Dr. Smith was askedpublished report the fact that more than half the workers exam- whether he had ever recommended to Johns-Manville officialsined--D7 of 126--were suffering from asbestosis.that warning labels be placed on insulation products contain- Meanwhile, SUl1U1er Simpson was writing F H. Schulter, ing asbestos. He provided the following testimony:president ofThermoid Rubber Company, to suggest that sev-The reasons why the caution labels were not implementederal manufacrurers sponsor further asbestos experiments. The immediately, it was a business decision as far as I could under-sponsors, said Simpson, could exercise oversight prerogatives; stand. Here was a recommendation, the corporation is in busi-they "could determine from time to time after the findings are ness to make, to provide jobs for people and make money formade whether they wish any publication or not." Addedstockholders and they had to take into consideration the effectsSimpson: "It would be a good idea to distribute the informa- of evelything they did, and if the application of a caution label identifying a product as hazardous would cut out sales, theretion to the medical fraternity, providing it is of the right type would be serious financial implications. And the powers that beand would not injure our companies." Lest there should behad to make some effort to judge the necessity of the label vs. the consequences of placing the label on the product.See Samuel S. Epstein, "The Asbestos Pentagon Papers: .. in Mark Greenand Roben Massie, Jr., eds., Tbe Big Business Read.,,: Essays 011 Co,porate Dr. Smiths testimony and related documents have figuredAmerica (New York: Pilgrim Press, 1980), 15+-5. This article is the primary prominently in hundreds of asbestos-related lawsuits, totalingsource of the facts and quotations reported here. more than $1 billion. In March 1981, a settlement was reached 38. CHAPTER AN INTRODUCTION TO FINANCIAL MANAGEMENT29in nine separate lawsuits brought by 680 New Jersey asbestos sion about the ill effects of asbestos exposure? Or does itworkers at a Raybestos-Manhattan plant. Several asbestos make sense to consider only the principal people involvedman~facturers, as well as Metropolitan Life Insurance, wereas morally responsible-for example, Simpson andnamed as defendants. Under the terms of the settlement, theBrown?workers affected will share in a $9.4 million court-2. Simpson and Brown presumably acted in what theyadministered compensation fund. Each worker will be paid thought were the best profit interests of their companies.compensation according to the length of exposure to asbestos Nothing they did was illegal. On what grounds, if any, areand the severity of the disease contracted.their actions open to criticism?By 1982, an average of 500 new asbestos cases were being3. Suppose that Simpson and Brown reasoned this way:filed each month against Manville (as Johns-Manville was now "While it may be in our firms short-term interests to sup-called), and the company was losing more than half the cases press data about the ill effects of asbestos exposure, in thethat went to trial. In 10 separate cases, juries had also awardedlong run it may ruin our companies. We could be sued forpunitive damages, averaging $616,000 a case. By August, 20,000 millions, and the reputation of the entire industry couldclaims had been filed against the company, and Manville filedbe destroyed. So we should reveal the true results of thefor bankruptcy in federal court. This action froze the lawsuits in asbestos-exposure research and let the chips fall wheretheir place and forced asbestos victims to stand in line withthey may." Would that be appropriate?other Manville creditors. After more than 3 years of legal hag- 4. If you were a stockholder in Raybestos-Manhattan orgling, Manvilles reorganization plan was finally approved by theJohns-Manville, would you approve of Simpson andbankruptcy court. The agreement set up a trust fund valued atBrowns conduct? If not, why not?approximately $2.5 billion to pay Manvilles asbestos claimants.5. "Hands of government" proponents would say that it isTo fund the trust, shareholders were required to surrender halfthe responsibility of government, not the asbestos indus-the value of their stock, and the company had to give up muchtry, to ensure health and safety with respect to asbestos. Inof its projected earnings over the next 25 years. bthe absence of appropriate government regulations,Claims, however, soon overwhelmed the trust, which ran asbestos manufacturers have no responsibility other thanout of money in 1990. With many victims still waiting for pay- to operate efficiently. Do you agree?ment, federal Judge Jack B. Weinstein ordered the trust to6. Does Dr. Smiths explanation for concealing from workersrestructure its payments and renegotiate Manvilles contribu-the nature of their health problems illustrate how adher-tions to the fund. As a result, the most seriously ill victims willence to industry and corporate goals can militate againstnow be paid first, but average payments to victims have been individual moral behavior? Or do you think Dr. Smith didlowered significantly, from $145,000 to $43,000. Meanwhile,all he was morally obliged to do as an employee of anthe trusts stake in Manville has been increased to 80 percent,asbestos firm? What about Lanzas suppression of data inand Manville has been required to pay $300 million to it inhis report?additional dividends. c 7. It has been shown that spouses of asbestos workers can develop lung damage and cancer simply by breathing theQuestionsfibers carried home on work clothes and that people living 1. Should the asbestos companies be held morally responsi-near asbestos plants experience higher rates of cancer thanble in the sense of being capable of making a moral deci-the general population does. Would it be possible to assign responsibility for these effects to individual mem-bSee Robert Mokhiber. COIpornte Crime ond Violeuce (San Francisco: Sierrabers of asbestos companies? Should the companies them-Club Books, 1988),285-86; and Arthur Sharplin, "Manville Lives on as selves be held responsible?Victims Continue to Die," Business o7ld Societ) Review 65 (Spring 1988): 27-28..J34% $75,001-$100,000 - . - ,- -"7>39% $100,gOl::.$335,OOO. -=--Q ;-. -;D~ 335,001-$10,000,000 Ii -- - 35% $10,000,001-$15,000,00038% $15,000,001-$18,333,33335% Over $18,333,333finns conunon stockholders. The taxable income for theJ&S Corporation would be $16million, as shown in Table 2-3.COMPUTING THE TAXES OWED The taxes to be paid by a corporation on its taxable income are based on the corporate tax rate structure. The specific rates effective forthe corporation, as of 2002, are given in Table 2-4. If you wonder about the economicrationale for the rates, dont waste your time. There is none. Politicians, not economists,determine the rates. Based on the tax rates, J&S Corporations tax liability would be $5,530,000, as computed in Table 2-5. The tax rates in Table 2-4 are defined as the marginal tax rates, or rates applicable toMarginal tax ratethe next dollar of taxable income. For instance, if a firm has taxable income of $60,000 The tax rate that would beand is contemplating an investment that would yield $10,000 in additional taxableapplied to the ~dollar of taxable income.income, the tax rate to be used in calculating the taxes on this added income is the 25 percent marginal tax rate. However, if the corporation already expects $20 million withoutthe new investment, the extra $10,000 in taxable income would be taxed at 35 percent,the marginal tax rate at the $20 million level of income. For theJ&S Corporation, with a taxable income of$16 million, its marginal tax rateis 38 percent; that is, any additional income from new investments will be taxed at a rateof 38 percent-at least until taxable income exceeds $18,333,333. Then the marginal taxrate would decline to 35 percent. Note, however, that while J&S Corporation has a38 percent marginal tax rate, its average tax rate-taxes owed relative to the firms taxAverage tax rateable income-is 34.6 percent ($5,:;30,000 -;- $16,000,000). Taxes owed by the firm divided For financial decision making, it is the marginal tax rate, rather than the average tax by the firms taxable income.rate, that matters because it is the marginal rate that is applied to any additional earningsresulting from a decision. Thus, when making financial decisions involving taxes, always 52. 44 PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT IZtJ!lEDTax Calculations for JEtS Corporation EARNINGS xMARGINAL TAX RATETAXES $50,000 x15%$7,500 $75,000-$50,000 x25% 6,250 $100,000-$75,000x34% 8,500 $335,000-$100,000 x39%91,650 $10,000,000-$335,000x34% 3,286,100 $15,000,000-$10,000,000 x35% 1,750,000 $16,000,000-$15,000,000 x38% 380,000 Total tax liability $5,530,000 use the marginal tax rate in your calculations and not the average tax rate. We cannot overemphasize the importance of remembering the preceding statement, which is a spe cific application of Principle 4-Its Only What Changes That Counts. We should always analyze decisions at the margin.The tax rate structure used in computing the J&S Corporations taxes assumes that the income occurs in the United States. Given the globalization of the economy, it may well be that some of the income originates in a foreign country. If so, the tax rates, and the method of taxing the firm, frequently vary. International tax rates can vary substantially and the job of the financial manager is to minimize the firms taxes by reporting as much income as legaily allowed in the low tax-rate countries and as little as legally allowed in the high tax-rate countries. Of course, other factors, such as political risk, may discourage efforts to minimize taxes across national borders. CONCEPT CHECK1. Distinguish among sole proprietors, partnerships, and corporations interms of how th.ey are taxed. 2.What is the difference between marginal tax rates and average tax rates? 3.Why do we use marginal tax rates, rather than average tax rates, whenmaking financial decisions? 4.What should be the firms goal when it comes to international taxes? Objective ~MEASURING FREE CASH FLOWS While an income statement measures a companys profits, profits are not the same as cash flows; profits are cl.lculated on an accrual basis rather than a cash basis. Accrual-basis accounting records income when it is earned, whether or not the income has been ({Aile. cvl.e 11 ~freceived in cash, and records expenses when they are incurred, even if money has not (C ). ~ H-L~1""I actually been paid out. For example, sales reported in the income statement include both cash sales and credit sales. Therefore, sales for a given year do not correspond exactly to the actual cash collected from sales. Similarly, a finn must purchase inventory, but someI_u:! 0 of the purchases are financed by credit rather than by immediate cash payment. Also, under the accrual system, the purchase of equipment that will last for more than 1 year is ~JS not shown as an expense in the income statement. Instead, the amount is recorded asan , , (1asset and then depreciated over its useful life. An annual depreciation expense (this is not C ~ a cash flow) is recorded as a way to match the use of the asset with sales generated from its service. We could give more examples to show why profits differ from cash flows, but the point should be clear: Profits and cash flows are not the same thing. Failure to understand and recognize this important fact could cause some real problems. 53. CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS, TAXES, AND CASH FLOWS 45 In measuring cash flows, we could use the conventional accountants presentationcalled a statement ofcash flows. However, we are more interested in considering cash flowsfrom the perspective of the firms investors, rather than from an accounting view. So,what follows is similar to a conventional cash flow statement presented as part of a companys financial statements, but "not exactly." (For a presentation of an accountants statement of cash flows, see Appendix 2-A.) We can think of a firm as a block of assets that produce cash flow, which can beeither positive or negative. Once the firm has paid all its operating expenses and made allits investments, the remaining cash flows are free to distribute to the firms creditors andshareholders-thus, the term free cash flows. However, if the free cash flows are nega Free cash flowstive, the~reditorS)andl1nvestors)are the ones who make up the shortfall-someone has to Amount of cash available fromdo it. Thus, the cash flows that are generated through a firms assets equal its cash flowsoperations after paying for investments in net operatingpaid to-or received from-the companys investors (both creditors and stockholders).working capital and fixedThey have to be equal; except that if one is positive (negative) the other will be negativeassets. This cash is available to(positive). That is, G r-distribute to the firms creditors el(;( I 1"(-3 Or cY -f. J.e", I,DS r.l and owners. +(-) Cash flows from assets = -~+) cash flows from financingThe two calculations simply give us different perspectives about the firms cash flows. So,lets look at each approach for measuring a companys free cash flows. CALCULATING FREE CASH FLOWS: AN ASSET PERSPECTIVE!A firms free cash flows, viewed from an asset perspective, are the after-tax cash flows gen/erated from operating the business less the firms investments in assets; that is: / / after-tax operating investment -----free cash flows = -. -- cash flows In assets~-put, management did not pay the full $298.1 million in taxes. Rather they accrued $2.01million of these taxes instead of paying them. So the cash taxes are computed as follows: Cash taxes = Provision for income taxes ..,.(Cha~} in income taxes payable.= $298.052 million - $2.011 ffillJihil = $296.041 million..... / )VFor the second step, the increase in net operating working capital is equal to the: r)I " ;.j I r_change intU.fchange in noninterest - bearing] [ current asset1..CVcurrent liabilities ) (~ (Cc. Earlier, we said that net working capital is equal to current assets minus current, or short /Noninterest-bearing term, debt. However, in computing free cash flows, we only consider the noninterest " current liabilitiesbearin current liabilities incurred in the normal day-to-day operating acti.rities of buyCurrent liabilities other than ing and selline Irm s goo s, suc as accounts ayah e an a~{penses~ Any short-tenn debt. Q.f.., interest-bearing debt (that IS, were you exp Icitly pay interestfor the u