The Foundation
1.6 Organization of the Book
Now that we have completed an introduction to financial management, we can take a closer look at the organization of this book. We focus on the fundamentals of financial manage- ment for profit-oriented businesses, especially corporations. Since we believe that the best way to learn finance is by applying its models, theories, and techniques, we provide numer- ous examples throughout the book.
Understanding Financial Management: A Practical Guide consists of 12 chapters in four parts.
Part I, “The Foundation,” contains five chapters providing the underpinnings of financial man- agement. In Chapter 1 we define financial management, discuss major types of financial decisions, and advocate shareholder wealth maximization as the financial goal of the firm.
Our next aim is to provide certain background materials and tools needed to make sound financial decisions that create value. Therefore, in Chapters 2 and 3 we discuss interpreting financial statements and conducting financial statement analysis primarily using ratios. In Chapters 4 and 5 we explore the topics of the time value of money and valuation. We develop basic procedures for valuing future cash flows with particular emphasis on stocks and bonds.
In Part II we focus on working capital management decisions. In Chapter 6 we examine various approaches to managing working capital including cash, accounts receivable, inventory, and payables. We also discuss short-term financing. In the past, the management of working
16 THEFOUNDATION
capital consumed much of a financial manager’s time. Today, long-term investment and financing decisions have assumed an increasingly important role in financial management.
In Part III we examine long-term investment decisions. Chapter 7 provides an overview of capital investment decisions and focuses on estimating project cash flows. We give a com- prehensive example of estimating cash flows for an expansion and a replacement project. In Chapter 8 we consider capital budgeting, which results in the acquisition of fixed assets.
In Chapter 9 we examine common ways to describe, assess, and adjust for risk associated with capital investments.
The final part, Part IV, focuses on long-term financing decisions. In Chapter 10 we discuss how business firms raise external capital and how investors trade securities. We examine how to determine the cost of three capital components: debt, preferred stock, and common equity. We also discuss how to calculate the weighted average cost of capital and the appropriate weights to use in this process. Finally, we examine how to calculate the marginal cost of capital and to determine the firm’s optimal capital budget.
Chapter 11 investigates the financing mix for a firm. We illustrate how a firm may use financial leverage to increase the expected returns to shareholders while increasing risk for the shareholders. We show how taxes and certain market frictions may make a firm’s capital structure decision relevant in the real world.
Finally, in Chapter 12, we focus on dividends and share repurchases because they are the principal mechanisms by which corporations disburse cash to their shareholders. We also discuss other related matters such as dividend reinvestment plans, stock dividends, stock splits, and reverse stock splits. We conclude that dividends can matter by affecting share- holder wealth because of various market imperfections and other factors.
In this book, we focus on core topics and leave the discussion of special topics such as mergers and acquisitions, risk management, leasing, financial distress, and international aspects of corporate finance to other sources. At the core of financial management are three interrelated decision areas: long-term investment, long-term financing, and working capital management (short-term) decisions. Taken together, these decisions determine the value of the firm to its shareholders. Creating value within a firm requires an understanding of financial management.
Summary
This chapter provides an introduction to some of the basic concepts underlying financial management. In this chapter, we stressed the following points:
1 Financial management is concerned with acquiring, financing, and managing assets to achieve a desired goal.
2 The financial management process involves three broad decision areas: (1) long- term investment decisions, (2) long-term financing decisions, and (3) working capital management decisions.
3 Financial decisions involve a risk–return tradeoff in which higher expected returns are accompanied by higher risk. The financial manager determines the appropriate risk–return tradeoff to maximize the value of the firm’s stock.
4 Corporations offer several advantages over other forms of business organization including unlimited life, limited liability, ease of transferring ownership, and ability to raise funds. Corporations also have shortcomings including cost and complexity, double taxation, and separation of ownership and management.
5 The primary financial goal of the firm is to maximize the wealth of its shareholders.
Shareholder wealth maximization is achieved in a public corporation by maximiz- ing the market price of the firm’s stock.
6 Maximizing shareholder wealth results from focusing on economic profit, not accounting profit.
7 Agency problems result when the interests of owners (principals) differ from the interests of managers (agents). Mechanisms available to align the interests of these parties include management compensation, direct shareholder intervention, threat of dismissal, and threat of takeovers.
FURTHERREADING
Brickley, James A., Clifford W. Smith, Jr, and Jerold L. Zimmerman, “Corporate Governance, Ethics, and Organizational Architecture,” Journal of Applied Corporate Finance 15, Spring 2003, 34–45.
Chambers, Donald R. and Nelson J. Lacey. “Corporate Ethics and Shareholder Wealth Maximization,”
Financial Practice and Education 6, Spring/Summer 1996, 83–96.
Cloninger, Dale O. “Managerial Goals and Ethical Behavior,” Financial Practice and Education 5, Spring/
Summer 1995, 50–59.
Damodaran, Aswath. Applied Corporate Finance: A User’s Manual, John Wiley & Sons, Inc., 1992.
Hu, H. T. C. “Behind the Corporate Hedge: Information and the Limits of ‘Shareholder Wealth Maximization,’ ” Journal of Applied Corporate Finance 9, 39–51.
Jensen, Michael C. “Value Maximization, Stakeholder Theory, and the Corporate Objective Function,”
Journal of Applied Corporate Finance 14, Fall 2001, 8–21.
Loderer, Claudio and Pius Zgraggen. “When Shareholders Choose Not to Maximize Value: The Union Bank of Switzerland’s 1994 Proxy Fight,” Journal of Applied Corporate Finance 12, Fall 1999, 91–102.
Miller, Merton H. “The History of Finance: An Eyewitness Account,” Journal of Applied Corporate Finance 13, Summer 2000, 8–14.
Rexer, Christian and Timothy J. Sheehan. “Organizing the Firm: Choosing the Right Business Entity,”
Journal of Applied Corporate Finance 7, Spring 1994, 59–65.
Shefrin, Hersh. “Behavioral Corporate Finance,” Journal of Applied Corporate Finance 14, Fall 2001, 113–24.
Smith, Michael P. “Shareholder Activism by Institutional Investors: Evidence from CalPERS,” Journal of Finance 51, March 1996, 227–52.
Wallace, James S. “Value Maximization and Stakeholder Theory: Compatible or Not?” Journal of Applied Corporate Finance 15, Spring 2003, 120–27.
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Chapter 2
Interpreting Financial Statements
At Berkshire, full reporting means giving you the information that we would wish you to give to us if our positions were reversed. What Charlie and I would want under that circumstance would be all the important facts about current operations as well as the CEO’s frank view of the long-term economic characteristics of the business. We would expect both a lot of financial details and a discussion of any significant data we would need to interpret what was presented. (Warren E. Buffett, Chairman of the Board, Berkshire Hathaway, Inc., 2000 Annual Report.)
Overview
This chapter discusses the basic financial statements issued by a firm including the balance sheet, income statement, statement of cash flows, and statement of retained earnings. We focus mainly on how financial managers can interpret the information reported in these statements. We emphasize the need to understand the difference between the accounting net income reported on the firm’s income statement and the actual net cash flow generated by the firm during that same period. We discuss how to construct and interpret vertical common-size balance sheets and income statements to facilitate the analysis of trends over time and to compare firms of different size.
Learning Objectives
After completing this chapter, you should be able to:
• understand why many different stakeholders need to understand and interpret a firm’s financial statements;
• describe the structure and understand the contents of a company’s balance sheet, income statement, statement of cash flows, and statement of retained earnings;
• explain the differences between net income and cash flow;
• recognize the limitations of historical accounting information;
• interpret the information provided in common-size financial statements.