Nature release

MANAGEMENT
AND POLICY

James C. Van Horne
Stanford Umversity

Prentice Hall, Upper Saddle River,New Jersey07458


To My Family

Library of Congress Cataloging-in-Publication Data
Van Horne, James C.
Financial management and policy / James C. Van Home. - 12th ed
p. cm.
Includes bibliographical references and index.
ISBN 0-13-032657-7
1. Corporations-Finance. I. Title.

00-051656
CIP

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ISBN 0-13-032657-7


Brief Contents
PART I
FOUNDATIONS OF FINANCE 1
Vignette: Problems at Gillette 1
CHAPTER
CHAPTER
CHAPTER
CHAPTER
CHAPTER


1 Goals and Functions of Finance

3
2 Concepts in Valuation 11
3 Market Risk and Returns 49
4 Multivariable and Factor Valuation 85
5 Option Valuation 103

PART I1
INVESTMENT IN ASSETS AND REQUIRED RETURNS 129
w Case: Fazio Pump Corporation 129
CHAPTER 6 Principles of Capital Investment 133
CHAPTER 7 Risk and Real Options in Capital Budgeting 165
CHAPTER 8 Creating Value through Required Returns 199
w Case: National Foods Corporation 241
PART I11
FINANCING AND DIVIDEND POLICIES 249
w Case: Restructuring the Capital Structure at Marriott 249
CHAPTER 9 T h e o y of Capital Structure 253
CHAPTER 10 Making Capital Structure Decisions 289
CHAPTER 11 Dividend and Share Repurchase: T h e o y and Practice

309


vi

Brief Contents


PART IV
TOOLS OF FINANCIAL ANALYSIS AND CONTROL 343
w Case: Morley Industries, Inc. 343
CHAPTER 12 Financial Ratio Analysis 349
Case: Financial Ratios and Industries 383
CHAPTER 13 Financial Planning 387
PART V
LIQUIDITY AND WORKING CAPITAL MANAGEMENT 421
w Case: Caceres Semilla S.A. de C.V. 421
CHAPTER 14 Liquidity, Cash, and Marketable Securities 429
CHAPTER 15 Management of Accounts Receivable and Inventories 449
CHAPTER 16 Liability Management and ShortlMedium-Term Financing 483

Part VI
CAPITAL MARKET FINANCING AND RISK MANAGEMENT 521
w Case: Dougall & Gilligan Global Agency 521
CHAPTER 17
CHAPTER 18
CHAPTER 19
CHAPTER 20
CHAPTER 21
CHAPTER 22

Foundations for Longer-Term Financing 529
Lease Financing 543
Issuing Securities 565
Fixed-Income Financing and Pension Liability 589
Hybrid Financing through Equity-Linked Securities 615
Managing Financial Risk 645


PART VII
EXPANSION AND CONTRACTION 673
w Case: Rayovac Corporation 673
CHAPTER 23 Mergers and the Market for Corporate Control 687
CHAPTER 24 Corporate and Distress Restructuring 719
CHAPTER 25 International Financial Management 747
APPENDIX: Present-Value Tables and Normal Probability Distribution Table 787


Contents
Preface xix

PART I

FOUNDATIONS OF FINANCE 1
Vignette: Problems at Gillette 1

1 Goals and Functions of Finance

3
Creation of Value 3
Investment Decision 6
Financing Decision 7
Dividend/Share Repurchase Decision 7
Bringing It All Together 8
Questions 8
Selected References 9

2


Concepts in Valuation fi
The Time Value of Money 11
Present Values 16
Internal Rate of Return or Yield 21
Bond Returns 23
Return from a Stock Investment 27
Dividend Discount Models 30
Measuring Risk: Standard Deviation 37
Summary 39
Self-correction Problems 41
Problems 42
Solutions to Self-correction Problems 45
Selected References 48

vii


viii

3

Contents

Market Risk and Returns 49
Efficient Financial Markets 49
Security Portfolios 51
.
,
Multiple Security Portfolio Analysis and Selection 57
Capital Asset Pricing Model 62

Expected Return for Individual Security 68
Certain Issues with the CAPM 72
Summary 75
Self-correction Problems 76
Problems 77
Solutions to Self-correction Problems 81
Selected References 82

4

Multivariable and Factor Valuation 85
Extended CAPM 85
Factor Models in General 90
Arbitrage Pricing Theory 93
Summary 96
Self-correction Problems 97
Problems 98
Solutions to Self-correction Problems 100
Selected References 100

5

o p t i o n Varuation 103
Expiration Date Value of an Option 103
Valuation with One Period to Expiration:
General Consideration 104
Binomial Option Pricing of a Hedged Position 109
The Black-Scholes Option Model 112
American Options 118
Debt and Other Options 121

Summary 121
Appendix: Put-Call Parity 122
Self-correction Problems 123
Problems 124
Solutions to Self-Correction Problems 126
Selected References 128

PART I1
INVESTMENT IN ASSETS AND REQUIRED RETURNS 129
w Case: Fazio Pump Corporation 129

6

Principles of Capital Investment 133
Administrative Framework 133
Methods for Evaluation 138
NPV versus IRR 143


Contents
Depreciation and Other Refinements in
Cash-Flow Information 146
What Happens When Capital Is Rationed? 148
Inflation and Capital Budgeting 150
Information to Analyze an Acquisition 152
Summary 154
Appendix: Multiple Internal Rates of Return 155
Self-correction Problems 157
Problems 158
Solutions to Self-correction Problems 161

Selected References 163

7 Risk and Real Options in Capital Budgeting

165

Quantifying Risk and its Appraisal 165
Total Risk for Multiple Investments 174
Real Options in Capital Investments 177
Summary 188
Self-correction Problems 188
Problems 190
Solutions to Self-Correction Problems 195
Selected References 197

8

Creating Value through Required Returns 199
Foundations of Value Creation 199
Required Market-Based Return for a Single Project 202
Modification for Leverage 206
Weighted Average Required Return 208
Adjusted Present Value 214
Divisional Required Returns 217
Company's Overall Cost of Capital 221
Diversification of Assets and Total Risk Analysis 223
Evaluation of Acquisitions 227
Summary 229
Self-correction Problems 230
Problems 232

Solutions to Self-correction Problems 237
Selected References 240
Case: National Foods Corporation 241

PART I11
FINANCING AND DIVIDEND POLICIES 249
Case: Restructuring the Capital Structure at Marriott 249

9 Theory of Capital Structure
Introduction to the Theory 253
Modigliani-Miller Position 257
Taxes and Capital Structure 261

253

i~


X

Contents
Effect of Bankruptcy Costs 268
Other Imperfections 270
Incentive Issues and Agency Costs 271
Financial Signaling 278
Summary 279
Self-correction Problems 279
Problems 280
Solutions to Self-correction Problems 284
Selected References 286


10

Making Capital Structure Decisions 289
EBIT-EPS Analysis 289
Cash-Flow Ability to Service Debt 292
Effect on Debt Ratios 296
Effecton Security Rating 268
Timing and Flexibility 297
A Pecking Order of Financing? 298
Checklist when it Comes to Financing 299
Summary 300
Self-Correction Problems 301
Problems 302
Solutions to Self-correction Problems 306
Selected References 307

11

Dividends and Share Repurchase: Theory and Practice
Procedural Aspects of Paying Dividends 309
Dividend Payout Irrelevance 310
Arguments for Dividend Payout Mattering 313
Financial Signaling 316
Empirical Testing and Implications for Payout 317
Share Repurchase 320
Stock Dividends and Stock Splits 324
Managerial Considerations as to
Dividend/Share-Repurchase Policy 328
Summary 332

Self-correction Problems 333
Problems 334
Solutions to Self-correction Problems 338
Selected References 341

PART IV
TOOLS OF FINANCIAL ANALYSIS AND CONTROL 343
w Case: Morley Industries, Inc. 343

12

Financial Ratio Analysis 349
Introduction to Financial Analysis 349
Liquidity Ratios 351

309


Contents
Debt Ratios 357
Coverage Ratios 358
Profitability Ratios 360
Market-Value Ratios 363
Predictive Power of Financial Ratios 365
Common Size and Index Analysis 367
Summary 371
Self-correction Problems 372
Problems 374
Solutions to Self-correction Problems 380
Selected References 383

w Case: Financial Ratios and Industries 383

13

Financial Planning 387
Methods of Analysis 387
Source and Use of Funds 388
Cash Budgeting 393
Pro Forma Statements 398
Sustainable Growth Modeling 403
Summary 410
Self-correction Problems 411
Problems 412
Solutions to Self-correction Problems 417
Selected References 419

PART V
LIQUIDITY AND WORKING CAPITAL MANAGEMENT 421
w Case: Caceres Semilla S.A. de C.V. 421

14

Liquidity, Cash, and Marketable Securities 429
Liquidity and its Role 429
Cash Management and Collections 431
Control of Disbursements 434
Investment in Marketable Securities 436
Summary 442
Self-correction Problems 442
Problems 444

Solutions to Self-correction Problems 445
Selected References 446

15

Management of Accounts Receivable and Inventories 449
Credit Policies 449
Collection Policy 455
Evaluating the Credit Applicant 459
Inventory Management and Control 463
Uncertainty and Safety Stock 467

xi


xii

contents
Inventory and the Financial Manager 470
Summary 471
Appendix: Application of Discriminant Analysis
to the Selection of Accounts 472
Self-correction Problems 475
Problems 476
Solutions to Self-correction Problems 479
Selected References 481

16

Liability Management and ShortlMediurn-Tm Fi~ancing 483

Liability Structure of a Company 483
Trade Credit Financing 488
Accrual Accounts as Spontaneous Financing 492
Unsecured Short-Term Loans 493
Secured Lending Arrangements 496
Intermediate-Term Debt 503
Protective Covenants and Loan Agreements 506
Summary 511
Self-correction Problems 511
Problems 512
Solutions to Self-correction Problems 516
Selected References 518

PART VI
CAPITAL MARKET FINANCING AND RISK MANAGEMENT 521
Case: Douglas & Gilligan Global Agency 521

17 Foundations for Longer-Term Financing

529

Purpose and Function of Financial Markets 529
Yield Curves and Their Use 533
Pricing Default Risk Off Treasuries 537
Summary 540
Self-correction Problems 540
Problems 541
Solutions to Self-Correction Problems 542
Selected References 542


18

Lease Financing 543
Features of a Lease 543
Accounting and Tax Treatments of Leases 545
Return to the Lessor 548
After-Tax Analysis of Lease versus Buy/Borrow 549
Sources of Value in Leasing 556
Summary 559
Self-correction Problems 559
Problems 560


Contents
Solutions to Self-correction Problems 562
Selected References 564

19

Issuing Securities 565
Public Offering of Securities 565
Government Regulations 568
Selling Common Stock through a Rights Issue 570
Financing a Fledgling 575
Information Effects 580
Summary 582
Self-correction Problems 583
Problems 583
Solutions to Self-correction Problems 585
Selected References 586


20 Fixed-Income Financing and Pension Liability

589

Features of Debt 589
Types of Debt Financing 593
Call Feature and Refunding 595
Private Placements 601
Preferred Stock 602
Pension Fund Liability 605
Summary 608
Self-correction Problems 609
Problems 610
Solutions to Self-correction Problems 612
Selected References 613

21

Hybrid Financing through Equity-Linked Securities 615
Use of Warrants 615
Convertible Securities 619
Valuation of Convertible Securities 623
Exchangeable Debt 627
Other Hybrid Securities 629
Summary 633
Appendix: Valuing Convertible Bonds in the Face of Firm Volatility,
Default Risks, and Fluctuating Interest Rates 634
Self-correction Problems 637
Problems 638

Solutions to Self-correction Problems 640
Selected References 641

22

Managing Financial Risk 645
Derivative Securities 645
Hedging Risk 646
Futures Markets 648
Forward Contracts 652

xiii


X ~ VC o n t e n t s
Option Contracts 654
Interest-RateSwaps 659
Credit Derivatives 664
Commodity Contracts 666
Summary 667
Self-correction Problems 668
Problems 669
Solutions to Self-Correction Problems 670
Selected References 671

PART VII

EXPANSION AND CONTRACTION 673
Case: Rayovac Corporation 673


23

Mergers and the Market for Corporate Control 687
What Is Control Worth? 687
Features of a Merger 688
Strategic Acquisitions Involving Stock 690
sources or Rearrangements of Value 695
Corporate Voting and Control 699
Tender Offers and Company Resistance 701
Empirical Evidence on Mergers and Takeovers 705
Summary 708
Self-correction Problems 709
Problems 711
Solutions to Self-correction Problems 714
Selected References 716

24

Corporate and Distress Restructuring 729
Divestitures in General 719
Voluntary Liquidation and Sell-Offs 721
Spin-Offs 721
Equity Carve-Outs 723
Going Private and Leveraged Buyouts 724
Leveraged Recapitalizations 729
Distress Restructuring 730
Gaming with the Rule of Absolute Priority 735
Summary 737
Self-correction Problems 738
Problems 740

Solutions to Self-Correction Problems 743
Selected References 744

25

International Financial Management 747
Some Background 747
Types of Exposure 752


Contents
Economic Exposure 753
Exposure of Expected Future Cash Flows 756
Currency Market Hedges 761
Should Exposure Be Managed? 766
Macro Factors Governing Exchange-Rate Behavior 767
Structuring International Trade Transactions 773
Summary 776
Appendix: Translation Exposure 778
Self-Correction Problems 780
Problems 782
Solutions to Self-correction Problems 784
Selected References 786

Appendix: Present-Value Tables and Normal
Probability Distribution Table 787
Index 797

XV



This edition remains dedicated to showing how a rich body of financial theory can
be applied to corporate decision making, whether it be strategic, analytical, or simply the routine decisions a financial manager faces everyday. The landscape of finance has changed a good deal since the last edition, and in this edition I try to
capture the changing environment. In this regard, it is useful to review the important changes.
One change you will note is the inclusion of a number of sidebars in the margins of chapters. These sidebars define important terms as well as give alternative
explanations and embellishment. Nine new boxed presentations appear, mostly of
an international nature, which add practical interest to various aspects of corporate finance. Three new cases are in this edition, and an existing case has been revised. In total there now are eight cases, covering major issues in financial analysis, valuation, and financing. Extensive references to the literature, many of which
are new, appear at the end of each chapter.
By chapter, the important changes follow. In Chapter 1, a new vignette on
Gillette appears, as do quotes on what companies say about their corporate objectives. The chapter has been streamlined. h Chapter 3, efficient markets are better
explained. An improved treatment of the tax effect appears in Chapter 4, "Multivariable and Factor Valuation." In Chapter 6, the use of EBITDA in analyzing an
acquisition candidate is presented. A number of changes appear in Chapters 8 and
9, which deal with required rates of return and capital structure. Such things as
market value added, adjusting costs of capital, and the discipline of the capital
markets on management appear. In Chapter 10, the EBIT/EPS breakeven analysis
section has been redone.
Chapter 11, "Dividends and Share Repurchase: Theory and Practice," has
been substantially revised. There is a new and extended treatment of share repurchase and its important and changing effect. The review of empirical evidence is
largely redone, and there is an extended treatment of the managerial implications
for dividends and share repurchase. Chapters 12 and 13, "Financial Ratio Analysis" and "Financial Planning," have been moved from the back of the book to precede chapters on working capital management and financing. Chapter 14 contains

xvi


a new discussion of electronic funds transfers, and Chapter 15 has new sections
dealing with credit scoring, outsourcing credit and collection procedures, and B2B
exchanges for acquiring inventories in the overall management of the supply
chain.
Chapter 16, "Liability Management and Short/Medium-Term Financing,"
consolidates and streamlines two previous chapters. In addition, there is new discussion of loan pricing. In Chapter 17, the section on inflation and interest rates

has been redone. The tax treatment of lease financing has been changed in Chapter
18 to reflect the current situation. Also in this chapter, the lease versus buy/borrow
example is completely redone. Finally, there is more emphasis on how changing
tax rates and residual values affect the relative value of a lease contract. In Chapter
19, "Issuing Securities," there is a new section on SEC registration procedures and
an entirely new treatment of venture capital and its role in financing the new enterprise.
The high-yield debt section in Chapter 20 has been extensively revised, in
keeping with changing conditions. The bond refunding example in this chapter
has been changed, and there is a revised treatment of private placements. Finally,
there is a new section on the tax treatment of preferred-stock dividends and on
tax-deductible preferred stock. Chapter 21, "Hybrid Financing through EquityLinked Securities," is importantly changed. A major new section on more exotic
securities used in corporate finance has been written, which includes PERCS,
DECS, CEPPS, YEELDS, LYONS,and CEPS. In addition, the growth option as it relates to the value of a convertible security is explored, and there is a crisper treatment of the option value of the stock component. Chapter 22 contains an important new section on credit derivatives. Also in this chapter, the interest-rate swap
example has been changed, and there is additional discussion of replacement risk.
The last three chapters of the book have been extensively revised as well. In
Chapter 23, "Mergers and the Market for Corporate Control," new sections appear
on control premiums and on valuation analyses to determine the worth of a
prospective acquisition. There is a new treatment of anti-takeover amendments,
with particular attention to the poison pill. Many new empirical studies on acquisitions are explored. In Chapter 24, the sections on spin-offs and on equity carveouts have been largely rewritten. Also in this chapter, many changes have been
made to the section on leveraged buyouts. With respect to distress restructuring,
there is a new section on the role played by "vulture" capitalists. The last chapter
of the book, "International Financial Management," has a new section on economic exposure to unexpected currency movements and how to analyze the direction and magnitude of the effect. There is a new treatment of currency forward
and futures contracts. A new example of interest-rate parity and covered interest
arbitrage appear in this chapter as well.
Although these are the important changes, all materials have been updated
and there are a number of minor changes in presentation. Collectively, these
should make the book more readable and interesting.

ANCILLARY MATERIALS
A number of materials supplement the main text. For the student, select end-ofchapter problems are set up in Excel format and are available from the Prentice

Hall Web site: www.prenhall.com/financecenter.These problems are denoted by
the computer symbol. In addition, each chapter, save for the first, contains self-cor-


xviii

P r efa ce
rection problems. In a handful of chapters, reference is made to FinCoach exercises. This math practice software program is available for viewing and purchase
at the PH Web site: www.prenhall,com/financecenter. A new Power Point feature
will be available off the PH Web site. The presentation has been credited by
Richard Gendreau, Bemidji State University, and can be accessed under student
Resources. At the end of each chapter, I make reference to John Wachowicz's
wonderful Web site: www.prenhall.com/wachowicz. He is a co-author of mine
for another text, and his constantly revised site provides links to hundreds of financial management Web sites, grouped according to major subject areas. Extensive references to other literature also appear at the end of each chapter. Finally,
Craig Holden, Indiana University, provides students with instructions for building
financial models through his Spreadsheet Modeling book and CD series. Spreadsheet Modeling comes as a book and a browser-accessed CD-ROM that teaches
students how to build financial models in Excel. This saleable product will be
shrink-wrapped with the text or available on its own.
For the instructor, there is a comprehensive Instructor's Manual, which contains suggestions for organizing the course, solutions to all the problems that appear at the end of the chapters, and teaching notes for the cases. Also available in
the Instructor's Manual are transparency masters of most of the figures in the text
(these also are available through the aforementioned Prentice Hall Web site). Solutions to the Excel problems in the text are available on the Prentice Hall Web site
under Instructor Resources. These Excel problems and solutions have been updated by Marbury Fagan, University of Richmond. Another aid is a Test-Item File
of extensive questions and problems. This is available in both hard copy and custom computerized test bank format, revised by Sharon H. Garrison, University of
Arizona, through your Prentice Hall sales representative.
The finance area is constantly changing. It is both stimulating and far reaching. I hope that Financial Management and Policy, 12th edition, imparts some of this
excitement and contributes to a better understanding of corporate finance. If so, I
will regard the book as successful.
JAMES C. VAN HORNE
Palo Alto, California


The author wishes to acknowledge the work of the following people in the creation
of this book.
University ofNew Mexico Dr. Gautam Vora
Anderson School of Management
Franklin and Marshall College
Dr. Glenn L. Stevens
Dr. Andrew L.H. Parkes East Central University


FOUNDATIONS
OF FINANCE

VIGNETTE: Problems a t Gillette

Through most of the 1990s Gillette was e growth stock par excellence, attracting
such legendary investors as Warren Buffett. From 1995 to 1998, share price increased threefold, compared with "only" a doubling of the Standard & Poor's 500
stock index. Its businesses were not high tech: razor blades and toiletries; stationery products (Parker, Waterman and Paper Mate pens and pencils); Braun
electric shaver, toothbrush, hair dryer, and coffee maker limes; and DuraceLl batteries. The latter company was acquired by Gillette in 1996 for nearly $8 billion, a
large sum in relation to profits and cash flow. Gillette seemed to be on a roll, and
its expected growth resulted in a high ratio of share price to earnings-the P/E ratio. Management was acclaimed for its vision and efficiency in creating value for
its shareholders. Products were distributed in over 200 countries. Gillette was consistently on the list of Fortune's most admired companies.
But there were problems lurking beneath the surface. Profit margins and asset turnover were beginning to erode. Certain noncore product lines acquired in
the past to diversify away from razor blades were not earning their economic
keep. In 1999 profits declined by 12 percent from the prior year, the first time this
had occurred in modern memory. The downward earnings trend continued in
2000, and share price declined by nearly 50 percent in a little over one year. To add
insult to injury, Gillette was rumored to be vulnerable to a takeover bid by ColgatePalmolive. Previously, Gillette had a market capitalization (share price multiplied
by number of shares outstanding) of $70 billion, double that of Colgate-Palmolive.
By mid-2000, however, the market capitalizations of the two companies were
nearly the same. Once growth begins to falter, the effect on the present value of expected future earnings (share price) takes a real hit, and Gillette experienced the

full brunt of this shift.
What to do? A reorientation to value creation was compelling. Management
efficiency needed to occur as well as a restructuring to get back to core competence
where returns could be earned in excess of what the financial markets required.
A new CEO, Michael C. Hawley, was appointed in 1999. His efforts were directed

1


2

Part I F o u n d a t i o n s of Finance
to reducing bloated receivable and inventory positions, which were roughly $1 billion in excess of what reasonable turnover ratios would suggest. The stationery
products division and the household products division were put up for sale. These
divisions provided only meager profitability. Getting back to core competence
meant a focus on razors and blades, associated grooming products, Braun oral care
products, and Duracell batteries. The fruits of this redirection will not be apparent
until 2001 and beyond.
Throughout this book, many of the themes as to value creation and asset
management efficiency taken up in this vignette will be explored.


CHAPTER

Goals and Functions

he modern-day financial manager is instrumental to a c o n -

sets and new products and (2) determining the best mix of financ-


pany's success. As cash flows pulsate through the organization,

ing and dividends in relation to a company's overall valuation.

T

this individual is at the heart of what is happening. If fi-

Investment of funds in assets and people determines the size

nance is to play a general management role i n the organization,

of the firm, its profits from operations, its business risk, and its liq-

the financial manager must be a team player who is constructively

uidity. Obtaining the best mix of financing and dividends determines

involved in operations, marketing, and the company's overall strategy.

the firm's financial charges and its financial risk; it also impacts its

Where once the financtal manager was charged only with such

va.uat~on.All of this demands a broad outlook and an alert creattv-

tasbs as keeping records, preparing financial reports, managing

ity that will influence almost all facets of the enterprise.


the company's cash position. paying bills, and, on occasion. obta~ning funds. !he broad domain today includes (1) investment in as-

Introductions are meant to be short and svreet, and so too
will be this chapter.

CREATION OF VALUE
The objective of a company must be to create value for its shareholders. Value is
represented by the market price of the company's common stock, which, in turn, is
a function of the firm's investment, financing, and dividend decisions. The idea is
to acquire assets and invest in new products and services where expected return
exceeds their cost, to finance with those instruments where there is particular
advantage, tax or otherwise, and to undertake a meaningful dividend policy for
stockholders.
Throughout this book, the unifylng theme is value creation. This occurs
when you do something for your shareholders that they cannot do for themselves.
It may be that a company enjoys a favorable niche in an attractive industry, and
this permits it to earn returns in excess of what the financial markets require
for the risk involved. Perhaps the financial manager is able to take advantage of
imperfections in the financial markets and acquire capital on favorable terms. If
the financial markets are highly efficient, as they are in many countries, we would
expect the former to be a wider avenue for value creation than the latter. Most

Financial goal
is to maximize shareholder wealth.


4

Part I Foundations of Finance
shareholders are unable to develop products on their own, so value creation here

certainly is possible. Contrast this with diversification, where investors are able to
diversify the securities they hold. Therefore, diversification by a company is unlikely to create much, if any, value.

Profit Maximization
versus Valiie Creation
Frequently, maximization of profits is regarded as the proper objective of the firm,
but it is not as inclusive a goal as that of maximizing shareholder value. For one
thing, total profits are not as important as earnings per share. Even maximization
of earnings per share, however, is not fully appropriate because it does not take account of the timing or duration of expected returns. Moreover, earnings per share
are based on accounting profits. Though these are certainly important, many feel
that operating cash flows are what matter most.
Another shortcoming of the objective of maximizing earnings per share is
that it does not consider the risk or uncertainty of the prospective earnings stream.
Some investment projects are far more risky than others. As a result, the prospective stream of earnings per share would be more uncertain if these projects were
undertaken. In addition, a company will be more or less risky depending on the
amount of debt in relation to equity in its capital structure. This financial risk is another uncertainty in the minds of investors when they judge the firm in the marketplace. Finally, an earnings per share objective does not take into account any
dividend the company might pay.
For the reasons given, an objective of maximizing earnings per share
usually is not the same as maximizing market price per share. The market price
of a firm's stock represents the value that market participants place on the
company.

Agency Problems
Agency costs
involve conflicts between
stakeholders-equity
holders, lenders, employees, suppliers, etc.

The objectives of management may differ from those of the firm's stockholders. In
a large corporation, the stock may be so widely held that stockholders cannot even

make known their objectives, much less control or influence management. Often
ownership and control are separate, a situation that allows management to act in
its own best interests rather than those of the stockholders.
We may think of management as agents of the owners. Stockholders, hoping
that the agents will act in the stockholders' best interests, delegate decision-making
authority to them. Jensen and Meckling were the first to develop a comprehensive
agency theory of the firm.' They show that the principals, in our case the stockholders, can assure themselves that the agent (management) will make optimal
decisions only if appropriate incentives are given and only if the agent is monitored. Incentives include stock options, bonuses, and perquisites, and they are directly related to how close management decisions come to the interests of stockholders.
Monitoring can be done by bonding the agent, systematically reviewing
management perquisites, auditing financial statements, and explicitly limiting
management decisions. These monitoring activities necessarily involve costs, an

'Michael C. Jensen and William H. Mecklii," Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Struciure," [ournnl ojFinancini Economics, 3 (October1976). 305-60.


C h a p t e r 1 G o a l s a n d F u n c t i o n s of F i n a n c e

5

inevitable result of the separation of ownership and control of a corporation. The
less the ownership percentage of the managers, the less the likelihood that they
will behave in a manner consistent with maximizing shareholder wealth and the
greater the need for outside stockholders to monitor their activities.
Agency problems also arise in creditors and equityholders having different
objectives, thereby causing each party to want to monitor the others. Similarly,
other stakeholders-employees, suppliers, customers, and communities-may
have different agendas and may want to monitor the behavior of equityholders
and management. Agency problems occur in investment, financing, and dividend decisions by a company, and we will discuss them throughout the book.


A Normative Goal

Share price
embraces risk and
expected return.

Because the principle of maximization of shareholder wealth provides a rational
guide for running a business and for the e€ficient allocation of resources in society,
we use it as our assumed objective in considering how financial decisions should be
made. The purpose of capital markets is to allocate savings efficiently in an economy, from ultimate savers to ultimate users of funds who invest in real assets. If savings are to be channeled to the most promising investment opportunities, a rational
economic criterion must govern their flow. By and large, the allocation of savings in
an economy occurs on the basis of expected return and risk. The market value of a
company's stock, embodying both of these factors, therefore reflects the market's
trade-off between risk and return. If decisions are made in keeping with the likely
effect on the market value of its stock, a firm will attract capital only when its investment opportunities justify the use of that capital in the overall economy. Any other
objective is likely to result in the suboptimal allocation of funds and therefore lead to
less than optimal capital formation and growth in the economy.

What Companies Say About Their Corporate Goal


6

P a r t I Foundations of Finance

Social goals
and economic
efficiency can work
together to benefit
multiple stakeholders.


Social Responsibility This is not to say that management should ignore social responsibility, such as protecting consumers, paying fair wages, maintaining fair hiring practices and safe working conditions, supporting education, and becoming actively involved in environmental issues l i e clean air and water. Stakeholders other
than stockholders can no longer be ignored. These stakeholders include creditors,
employees, customers, suppliers, communities in which a company operates, and
others. The impact of decisions on them must be recognized. Many people feel that
a company has no choice but to act in socially responsible ways; they argue that
shareholder wealth and, perhaps, the corporation's very existence depend on its being socially responsible. Because criteria for social responsibility are not clearly
defined, however, it is difficult to formulate a consistent objective. When society,
acting through Congress and other representative bodies, establishes the rules
governing the trade-off between social goals and economic efficiency, the task for
the corporation is clearer. The company can be viewed as producing both private
and social goods, and the maximization of shareholder wealth remains a viable
corporate objective.
Functions of Finance The functions of finance involve three major decisions a
company must make: the investment decision, the financing decision, and the
dividend/share repurchase decision. Each must be considered in relation to our
objective; an optimal combination of the three will create value.

INVESTMENT DECISION

Investments in capital
projects should provide
expected returns ~nexcess of what f ~ n a n c ~ a l
markets requlre.

The investment decision is the most important of the three decisions when it
comes to the creation of value. Capital investment is the allocation of capital to
investment proposals whose benefits are to be realized in the future. Because the
future benefits are not known with certainty, investment proposals necessarily
involve risk. Consequently, they should be evaluated in relation to their expected

return and risk, for these are the factors that affect the firm's valuation in the
marketplace. Included also under the investment decision is the decision to reallocate capital when an asset no longer economically justifies the capital comrnitted to it. The investment decision, then, determines the total amount of assets
held by the firm, the composition of these assets, and the business-risk complexion of the firm as perceived by suppliers of capital. The theoretical portion of this
decision is taken up in Part 11. Using an appropriate acceptance criterion, or required rate of return, is fundamental to the investment decision. Because of the
paramount and integrative importance of this issue, we shall pay considerable
attention to determining the appropriate required rate of return for an investment project, for a division of a company, for the company as a whole, and for a
prospective acquisition.
In addition to selecting new investments, a company must manage existing assets efficiently. Financial managers have varying degrees of operating responsibility for existing assets; they are more concerned with the management
of current assets than with fixed assets. In Part V we explore ways in which to
manage current assets efficiently to maximize profitability relative to the
amount of funds tied up in an asset. Determining a proper level of liquidity is
very much a part of this management, and its determination should be in keeping with the company's overall valuation. Although financial managers have little or no operating responsibility for fixed assets and inventories, they are in-


Chapter 1 Goals a n d Functions of Finance

7

strumental in allocating capital to these assets by virtue of their involvement in
capital investment.
In Parts I1 and VII, we consider mergers and acquisitions from the standpoint of an investment decision. These external investment opportunities can be
evaluated in the same general manner as an investment proposal that is generated internally. The market for corporate control is ever present in this regard,
and this topic is taken up in Part VII. Growth in a company can be internal, external, or both, domestic, and international. Therefore, Part VII also considers
growth through international operations. With the globalization of finance in recent years, this book places substantial emphasis on international aspects of financial decision making.

FINANCING DECISION
Capital structure involves
determining the best mix of
debt, equity, and hybrid securities to employ.


In the second major decision of the firm, the financing decision, the financial manager is concerned with determining the best financing mix or capital structure. If a
company can change its total valuation by varying its capital structure, an optimal
financing mix would exist, in which market price per share could be maximized. In
Chapters 9 and 10 of Part 111, we take up the financing decision in relation to the
overall valuation of the company. OUTconcern is with exploring the implications of
variation in capital structure on the valuation of the firm. In Chapter 16, we examine
short- and intermediate-term financing. This is followed in Part VI with an investigation of the various methods of long-term financing. The emphasis is on not only
certain valuation underpinnings but also the managerial aspects of financing, as we
analyze the features, concepts, and problems associated with alternative methods.
Part VI also investigates the interface of the firm with the capital markets,
the ever-changing environment in which financing decisions are made, and how
a company can manage its financial risk through various hedging devices. In
Part VII, corporate and distress restructuring are explored. Although aspects of
restructuring fall across all three major decisions of the firm, this topic invariably involves financing, either new sources or a rearrangement of existing
sources.

DIVIDENDISHARE REPURCHASE DECISION
Excess cash can be dlstributed to stockholders dlrectly
through div~dendsor indlrectly via share repurchase.

The third important decision of a company is the amount of cash to distribute to
stockholders, which is examined in Chapter 11. There are two methods of distribution: cash dividends and share repurchase. Dividend policy includes the percentage of earnings paid to stockholders in cash dividends, the stability of absolute
dividends about a trend, stock dividends, and stock splits. Share repurchase allows the distribution of a large amount of cash without tax consequence to those
who choose to continue to hold their shares. The dividendpayout ratio and the
number of shares repurchased determine the amount of earnings retained in a
company and must be evaluated in light of the objective of maximizing shareholder wealth. The value, if any, of these actions to investors must be balanced
against the opportunity cost of the retained earnings lost as a means of equity financing. Both dividends and share repurchases are important financial signals to
the market, which continually tries to assess the future profitability and risk of a
corporation with publicly traded stock.



8

Part I Foundations of Finance

BRINGING IT ALL TOGETHER

Financial management endeavors to make optimal investment, financing and dividendlshare repurchase
decisions.

The purpose of this book is to enable readers to make sound investment, financing, and dividend/share repurchase decisions. Together, these decisions determine
the value of a company to its shareholders. Moreover, they are interrelated. The
decision to invest in a new capital project, for example, necessitates financing the
investment. The financing decision, in turn, influences and is influenced by the
dividend/share repurchase decision, for retained earnings used in internal financing represent dividends forgone by stockholders. With a proper conceptual framework, joint decisions that tend to be optimal can be reached. The main thing is that
the financial manager relate each decision to its effect on the valuation of the firm.
Because valuation concepts are basic to understanding financial management, these concepts are investigated in depth in Chapters 2 through 5. Thus, the
first five chapters serve as the foundation for the subsequent development of the
book. They introduce key concepts: the time value of money, market efficiency,
risk-return trade-offs, valuation in a market portfolio context, and the valuation
of relative financial claims using option pricing theory. These concepts will be applied in the remainder of the book.
In an endeavor to make optimal decisions, the financial manager makes
use of certain analytical tools in the analysis, planning, and control activities of
the firm. Financial analysis is a necessary condition, or prerequisite, for making
sound financial decisions; we examine the tools of analysis in Part IV. One of
the important roles of a chief financial officer is to provide accurate information
on financial performance, and the tools taken up will be instrumental in this regard.

1. Why should a company concentrate primarily on wealth maximization instead
of profit maximization?

2. "A basic rationale for the objective of maximizing the wealth position of the
stockholder as a primary business goal is that such an objective may reflect the
most efficient use of society's economic resources and thus lead to a maximization of society's economic wealth." Briefly evaluate this observation.
3. Beta-Max Corporation is considering two investment proposals. One involves the
development of 10 discount record stores in Chicago. Each store is expected to
provide an annual after-tax profit of $35,000 for 8 years, after which the lease will
expire and the store will terminate. The other proposal involves a classical record
of the month club. Here, the company will devote much effort to teaching the
public to appreciate classical music. Management estimates that after-tax profits
will be zero for 2 years, after which they will grow by $40,000 a year through year
10 and remain level thereafter. The life of the second project is 15 years. On the
basis of this information, which project do you prefer? Why?
4. What are the major functions of the financial manager? What do these functions have in common?
5. Should the managers of a company own sizable amounts of stock in the company? What are the pros and cons?
6. In recent years, there have been a number of environmental, pollution, hiring,
and othe; replations imposed on businesses. In view of these changes, is
maximizationof shareholder wealth still a realistic objective?


C h a p t e v 1 G o a l s a n d F u n c t i o n s of F i n a n c e

9

7. As an investor, do you believe that some managers are paid too much? Do not
their rewards come at your expense?
8. How does the notion of risk and reward govern the behavior of financial managers?

ALLEN, FRANKLIN, and ANDREW WINSTON, "Corporate
Financial Structure, Incentives and Optimal
Contracting," in R. A. Jarrow, V. Maksimovic,

and W. T. Ziemba, editors, North-Holland
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"Agency Costs and Ownership Structure,"
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BERNSTEIN,
PETER L., Capital Ideas. New York: Free
Press, 1992.
BRENNAN,
MICHAEL J., "Corporate Finance over the
Past 25 Years," F~nancialManagement, 24 (Summer 1995), 9-22.
COCHRANE,
JOHN H., "NEW FACTS IN FINANCE," working paper, National Bureau of Economic Research
(June 1999).
DE~GIJC-KLJN?;
ASLI, and VOJISLAV
MAKSMOVIC,
"Law, Finance, and Firm Growth," Journal of
Finance, 53 (December 1998), 2107-37.
HART,OLIVER, Firms, Contracts and Financial Structure.
Oxford: Oxford University Press, 1995.
JENSEN, MICHAELC., and WILLIAM H. MECKLING,
"Theory of the Firm: Managerial Behavior,

Agency Costs and Ownership Structure," Journal of Financial Economics, 3 (October 1976),
305-60.
MEGGINSON,
WILLIAM L., Corporate Finance Theoy.
Reading, Mass.: Addison-Wesley, 1997.
MYERS, STEWART C., "Outside Equity," Journal of Finance, 55 (June 2000), 1005-38.

RAJAN, RAGHURAM, and LUIGI ZINGALES,
"Financial
Dependence and Growth," American Economic
Review, 88 (June 1998), 559-87.
RAPPAPORT, ALFRED, Creating Shnreholder Value. New
York: Free Press, 1998.
TREYNOR,
JACK L., "The Financial Objective in the
Widely Held Corporation," Financial Analysts
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ZINGALES, LUIGI,"In Search of New Foundations,"
Working paper, National Bureau of Economic Research (May 2000).

Wachowicz's Web World is an excellent overall Web site
produced and maintained by my co-author of
Fundamentals of Financial Management, John M.
Wachowicz Jr. It contains descriptions of and
links to many finance Web sites and articles.
www.prenhall.com/wachowicz.