Accounting for Differences

While generally accepted accounting principles go a long way to standardize accounting practice in the United States, accountants still have some leeway in reporting earnings and book values. Financial analysts have even more leeway in how to use those reports; for example, some analysts will include profits or losses from extraordinary or nonrecurring events when they report net income, but others will not. Similarly, accountants have discretion concerning the treatment of intangible assets such as patents, trademarks, or franchises. Some believe that including these intangibles on the balance sheet provides the best measure of the company’s value as an ongoing concern. Others take a more conservative approach, and they exclude intangible assets. This approach is
better suited for measuring the liquidation value of the firm.
Another source of imprecision arises from the fact that firms are not required to include all their liabilities on the balance sheet. For example, firms are not always required to include as liabilities on the balance sheet the value of their lease obligations. They likewise are not required to include the value of several potential obligations such as warrants6 sold to investors or issued to employees.
Even bigger differences can arise in international comparisons. Accounting practices can vary greatly from one country to another. For example, in the United States firms generally maintain one set of accounts that is sent to investors and a different set of accounts that is used to calculate their tax bill. That would not be allowed in most countries. On the other hand, United States standards are more stringent in most other regards. For example, German firms have far greater leeway than United States firms to tuck money away in hidden reserve accounts.
When Daimler-Benz AG, producer of the Mercedes-Benz automobile, decided to list its shares on the New York Stock Exchange in 1993, it was required to revise its accounting practices to conform to United States standards. While it reported a modest profit in the first half of 1993 using German accounting rules, it reported a loss of $592 million under the much more revealing United States rules, primarily because of differences in the treatment of reserves.
Such differences in international accounting standards pose a problem for financial analysts who attempt to compare firms using data from their financial statements. This is why foreign firms must restate their financial results using the generally accepted accounting principles (GAAP) of the United States before their shares can be listed on a U.S. stock exchange. Many firms have been reluctant to do this and have chosen to list their shares elsewhere.
Other countries allow foreign firms to be listed on stock exchanges if their financial statements are prepared according to International Accounting Standards (IAS) rules, which impose considerable uniformity in accounting practices and are nearly as revealing as U.S. standards. The nearby box reports on current negotiations for international accounting standards.
The lesson here is clear. While accounting values are often the starting point for the financial analyst, it is usually necessary to probe more deeply. The financial manager needs to know how the values on the statements were computed and whether there are important assets or liabilities missing altogether.
The trend today is toward greater recognition of the market values of various assets and liabilities. Firms are now required to acknowledge on the balance sheet the value of unfunded pension liabilities and other postemployment benefits, such as medical benefits. In addition, a growing (although still controversial) trend toward “market-value accounting” would have them record many assets at market value rather than at historical book value.
Taxes
Taxes often have a major effect on financial decisions. Therefore, we should explain how corporations and investors are taxed.
CORPORATE TAX
Companies pay tax on their income. Table A.4 shows that there are special low rates of corporate tax for small companies, but for large companies (those with income over $18.33 million) the corporate tax rate is 35 percent. Thus for every $100 that the firm earns it pays $35 in corporate tax.
When firms calculate taxable income they are allowed to deduct expenses. These expenses include an allowance for depreciation. However, the Internal Revenue Service (IRS) specifies the rates of depreciation that the company can use for different types of equipment. The rates of depreciation that are used to calculate taxes may differ from the rates that are used when the firm reports its profits to shareholders.
The company is also allowed to deduct interest paid to debtholders when calculating its taxable income, but dividends paid to shareholders are not deductible. These dividends are therefore paid out of after-tax income. Table A.5 provides an example of how interest payments reduce corporate taxes.

The Balance Sheet

We will look first at the balance sheet, which presents a snapshot of the firm’s assets and the source of the money that was used to buy those assets. The assets are listed on the left-hand side of the balance sheet. Some assets can be turned more easily into cash than others; these are known as liquid assets. The accountant puts the most liquid assets at the top of the list and works down to the least liquid.
Look, for example, at the left-hand column of Table A.1, the balance sheet for PepsiCo, Inc., at the end of 1998. You can see that Pepsi had $311 + $83 = $394 million of cash and marketable securities. In addition it had sold goods worth $2,453 million but had not yet received payment. These payments are due soon and therefore the balance sheet shows the unpaid bills or accounts receivable (or simply receivables) as an asset.
The next asset consists of inventories. These may be (1) raw materials and ingredients that the firm bought from suppliers, (2) work in process, and (3) finished products waiting to be shipped from the warehouse. Of course there are always some items that don’t fit into neat categories. So the current assets category includes a fourth entry, other current assets.

Up to this point all the assets in Pepsi’s balance sheet are likely to be used or turned into cash in the near future. They are therefore described as current assets. The next group of assets in the balance sheet is known as fixed assets such as buildings, equipment, and vehicles.
The balance sheet shows that the gross value of Pepsi’s fixed assets is $13,110 million.
This is what the assets originally cost. But they are unlikely to be worth that now. For example, suppose the company bought a delivery van 2 years ago; that van may be worth far less now than Pepsi paid for it. It might in principle be possible for the accountant to estimate separately the value today of the van, but this would be costly and somewhat subjective. Accountants rely instead on rules of thumb to estimate the depreciation in the value of assets and with rare exceptions they stick to these rules. For example, in the case of that delivery van the accountant may deduct a third of the original cost each year to reflect its declining value. So if Pepsi bought the van 2 years ago for $15,000, the balance
sheet would show that accumulated depreciation is 2 × $5,000 = $10,000. Net of depreciation the value is only $5,000. Table A.1 shows that Pepsi’s total accumulated depreciation on fixed assets is $5,792 million. So while the assets cost $13,110 million, their net value in the accounts is only $13,110 – $5,792 = $7,318 million.
The fixed assets in Pepsi’s balance sheet are all tangible assets. But Pepsi also has valuable intangible assets, such as its brand name, skilled management, and a welltrained labor force. Accountants are generally reluctant to record these intangible assets in the balance sheet unless they can be readily identified and valued.
There is, however, one important exception. When Pepsi has acquired other businesses in the past, it has paid more for their assets than the value shown in the firms’ accounts. This difference is shown in Pepsi’s balance sheet as “goodwill.” The greater part of the intangible assets on Pepsi’s balance sheet consists of goodwill.


Now look at the right-hand portion of Pepsi’s balance sheet, which shows where the money to buy the assets came from. The accountant starts by looking at the company’s liabilities—that is, the money owed by the company. First come those liabilities that are likely to be paid off most rapidly. For example, Pepsi has borrowed $3,921 million, due to be repaid shortly. It also owes its suppliers $3,870 million for goods that have been delivered but not yet paid for. These unpaid bills are shown as accounts payable (or payables). Both the borrowings and the payables are debts that Pepsi must repay within the year. They are therefore classified as current liabilities.
Pepsi’s current assets total $4,362 million; its current liabilities amount to $7,914 million. Therefore the difference between the value of Pepsi’s current assets and its current liabilities is $4,362 – $7,914 = –$3,552 million. This figure is known as Pepsi’s net current assets or net working capital. It roughly measures the company’s potential reservoir of cash. Unlike Pepsi, most companies maintain positive net working capital.
Below the current liabilities Pepsi’s accountants have listed the firm’s long-term liabilities—that is, debts that come due after the end of a year. You can see that banks and other investors have made long-term loans to Pepsi of $4,028 million.
Pepsi’s liabilities are financial obligations to various parties. For example, when
Pepsi buys goods from its suppliers, it has a liability to pay for them; when it borrows from the bank, it has a liability to repay the loan. Thus the suppliers and the bank have first claim on the firm’s assets. What is left over after the liabilities have been paid off belongs to the shareholders. This figure is known as the shareholders’ equity. For Pepsi the total value of shareholders’ equity amounts to $6,401 million. A small part of this sum ($1,195 million) has resulted from the sale of shares to investors. The remainder ($5,206 million) has come from earnings that Pepsi has retained and invested on shareholders’ behalf.
Figure A.1 shows how the separate items in the balance sheet link together. There are two classes of assets—current assets, which will soon be used or turned into cash, and long-term or “fixed” assets, which may be either tangible or intangible. There are also two classes of liability—current liabilities, which are due for payment shortly, and longterm liabilities. The difference between the assets and the liabilities represents the amount of the shareholders’ equity.

Planners Beware

PITFALLS IN MODEL DESIGN
The Executive Fruit model is still too simple for practical application. You probably have already noticed several ways to improve it. For example, we ignored depreciation of fixed assets. Depreciation is important because it provides a tax shield. If Executive Fruit deducts depreciation before calculating its tax bill, it could plow back more money into new investments and would need to borrow less. We also ignored the fact that there would probably be some interest to pay in 2000 on the new borrowing, which would cut into the cash for new investment.
You would certainly want to make these obvious improvements. But beware: there is always the temptation to make a model bigger and more detailed. You may end up with an exhaustive model that is too cumbersome for routine use.
Exhaustive detail gets in the way of the intended use of corporate planning models, which is to project the financial consequences of a variety of strategies and assumptions. The fascination of detail, if you give in to it, distracts attention from crucial decisions like stock issues and dividend policy and allocation of capital by business area.
THE ASSUMPTION IN PERCENTAGE OF SALES MODELS
When forecasting Executive Fruit’s capital requirements, we assumed that both fixed assets and working capital increase proportionately with sales. For example, the black line in Figure 1.18 shows that net working capital is a constant 10 percent of sales. Percentage of sales models are useful first approximations for financial planning. However, in reality, assets may not be proportional to sales. For example, we will see that important components of working capital such as inventories and cash balances will generally rise less than proportionately with sales. Suppose that Executive Fruit looks back at past variations in sales and estimates that on average a $1 rise in sales requires only a $.075 increase in net working capital. The blue line in Figure 1.18 shows
the level of working capital that would now be needed for different levels of sales. To allow for this in the Executive Fruit model, we would need to set net working capital equal to ($50,000 + .075 × sales).
A further complication is that fixed assets such as plant and equipment are typically not added in small increments as sales increase. Instead, the picture is more likely to resemble Figure 1.19. If Executive Fruit’s factories are operating at less than full capacity (point A, for example), then the firm can expand sales without any additional investment in plant. Ultimately, however, if sales continue to increase, say beyond point B, Executive Fruit will need to add new capacity. This is shown by the occasional large changes to fixed assets in Figure 1.19. These “lumpy” changes to fixed assets need to be recognized when devising the financial plan. If there is considerable excess capacity, even rapid sales growth may not require big additions to fixed assets. On the other hand, if the firm is already operating at capacity, even small sales growth may call for large investment in plant and equipment.

 

 THE ROLE OF FINANCIAL PLANNING MODELS
Models such as the one that we constructed for Executive Fruit help the financial manager to avoid surprises. If the planned rate of growth will require the company to raise external finance, the manager can start planning how best to do so.
We commented earlier that financial planners are concerned about unlikely events as well as likely ones. For example, Executive Fruit’s manager may wish to consider how the company’s capital requirement would change if profit margins come under pressure and the company generated less cash from its operations. Planning models make it easy to explore the consequences of such events.
However, there are limits to what you can learn from planning models. Although
they help to trace through the consequences of alternative plans, they do not tell the manager which plan is best. For example, we saw that Executive Fruit is proposing to grow its sales and earnings per share. Is that good news for shareholders? Well, not necessarily; it depends on the opportunity cost of the additional capital that the company needs to achieve that growth. In 2000 the company proposes to invest $100,000 in fixed assets and working capital. This extra investment is expected to generate $12,000 of additional income, equivalent to a return of 12 percent on the new investment. If the cost of that capital is less than 12 percent, the new investment will have a positive NPV and
will add to shareholder wealth. But suppose that the cost of capital is higher at, say, 15 percent. In this case Executive Fruit’s investment makes shareholders worse off, even though the company is recording steady growth in earnings per share and dividends.
Executive Fruit’s planning model tells us how much money the firm must raise to fund the planned growth, but it cannot tell us whether that growth contributes to shareholder value. Nor can it tell us whether the company should raise the cash by issuing new debt or equity.

Financial Planning Models

Financial planners often use a financial planning model to help them explore the consequences of alternative financial strategies. These models range from simple models, such as the one presented later, to models that incorporate hundreds of equations.
Financial planning models support the financial planning process by making it
easier and cheaper to construct forecast financial statements. The models automate an important part of planning that would otherwise be boring, time-consuming, and laborintensive.
Programming these financial planning models used to consume large amounts of
computer time and high-priced talent. These days standard spreadsheet programs such as Microsoft Excel are regularly used to solve complex financial planning problems.
COMPONENTS OF A FINANCIAL PLANNING MODEL
A completed financial plan for a large company is a substantial document. A smaller corporation’s plan would have the same elements but less detail. For the smallest, youngest businesses, financial plans may be entirely in the financial managers’ heads.
The basic elements of the plans will be similar, however, for firms of any size.
Financial plans include three components: inputs, the planning model, and outputs.
The relationship among these components is represented in Figure 1.16. Let’s look at these components in turn.
Inputs. The inputs to the financial plan consist of the firm’s current financial statements and its forecasts about the future. Usually, the principal forecast is the likely growth in sales, since many of the other variables such as labor requirements and inventory levels are tied to sales. These forecasts are only in part the responsibility of the financial manager. Obviously, the marketing department will play a key role in forecasting sales. In addition, because sales will depend on the state of the overall economy, large firms will seek forecasting help from firms that specialize in preparing macroeconomic and industry forecasts.
The Planning Model. The financial planning model calculates the implications of
the manager’s forecasts for profits, new investment, and financing. The model consists of equations relating output variables to forecasts. For example, the equations can show how a change in sales is likely to affect costs, working capital, fixed assets, and financing requirements. The financial model could specify that the total cost of goods produced may increase by 80 cents for every $1 increase in total sales, that accounts receivable will be a fixed proportion of sales, and that the firm will need to increase fixed assets by 8 percent for every 10 percent increase in sales.
Outputs. The output of the financial model consists of financial statements such as income statements, balance sheets, and statements describing sources and uses of cash.
These statements are called pro formas, which means that they are forecasts based on the inputs and the assumptions built into the plan. Usually the output of financial models also include many financial ratios. These ratios indicate whether the firm will be financially fit and healthy at the end of the planning period.
AN EXAMPLE OF A PLANNING MODEL
We can illustrate the basic components of a planning model with a very simple example. In the next section we will start to add some complexity.

FIGURE 1.16
The components of a financial plan.

What Is Financial Planning?

Financial planning is a process consisting of:
1. Analyzing the investment and financing choices open to the firm.
2. Projecting the future consequences of current decisions.
3. Deciding which alternatives to undertake.
4. Measuring subsequent performance against the goals set forth in the financial plan.
Notice that financial planning is not designed to minimize risk. Instead it is a process of deciding which risks to take and which are unnecessary or not worth taking.
Firms must plan for both the short-term and the long-term. Short-term planning
rarely looks ahead further than the next 12 months. It is largely the process of making sure the firm has enough cash to pay its bills and that short-term borrowing and lending are arranged to the best advantage.
Here we are more concerned with long-term planning, where a typical planning
horizon is 5 years (although some firms look out 10 years or more). For example, it can take at least 10 years for an electric utility to design, obtain approval for, build, and test a major generating plant.
FINANCIAL PLANNING FOCUSES ON THE BIG PICTURE
Many of the firm’s capital expenditures are proposed by plant managers. But the final budget must also reflect strategic plans made by senior management. Positive-NPV opportunities occur in those businesses where the firm has a real competitive advantage.
Strategic plans need to identify such businesses and look to expand them. The plans also seek to identify businesses to sell or liquidate as well as businesses that should be allowed to run down.
Strategic planning involves capital budgeting on a grand scale. In this process, financial planners try to look at the investment by each line of business and avoid getting bogged down in details. Of course, some individual projects are large enough to have significant individual impact. When Walt Disney announced its intention to build a new theme park in Hong Kong at a cost of $4 billion, you can bet that this project was explicitly analyzed as part of Disney’s long-range financial plan. Normally, however, financial planners do not work on a project-by-project basis. Smaller projects are aggregated into a unit that is treated as a single project.
At the beginning of the planning process the corporate staff might ask each division to submit three alternative business plans covering the next 5 years:
1. A best case or aggressive growth plan calling for heavy capital investment and rapid growth of existing markets.
2. A normal growth plan in which the division grows with its markets but not significantly at the expense of its competitors.
3. A plan of retrenchment if the firm’s markets contract. This is planning for lean economic times.
Of course, the planners might also want to look at the opportunities and costs of
moving into a wholly new area where the company may be able to exploit some of its existing strengths. Often they may recommend entering a market for “strategic” reasons—that is, not because the immediate investment has a positive net present value, but because it establishes the firm in a new market and creates options for possibly valuable follow-up investments.
As an example, think of the decision by IBM to acquire Lotus Corporation for $3.3 billion. Lotus added less than $1 billion of revenues, but Lotus with its Notes software has considerable experience in helping computers talk to each other. This know-how gives IBM an option to produce and market new products in the future.
Because the firm’s future is likely to depend on the options that it acquires today, we would expect planners to take a particular interest in these options.
In the simplest plans, capital expenditures might be forecast to grow in proportion to sales. In even moderately sophisticated models, however, the need for additional investments will recognize the firm’s ability to use its fixed assets at varying levels of intensity by adjusting overtime or by adding additional shifts. Similarly, the plan will alert the firm to needs for additional investments in working capital. For example, if sales are forecast to increase, the firm should plan to increase inventory levels and should expect an increase in accounts receivable.
Most plans also contain a summary of planned financing. This part of the plan
should logically include a discussion of dividend policy, because the more the firm pays out, the more capital it will need to find from sources other than retained earnings.
Some firms need to worry much more than others about raising money. A firm with limited investment opportunities, ample operating cash flow, and a moderate dividend payout accumulates considerable “financial slack” in the form of liquid assets and unused borrowing power. Life is relatively easy for the managers of such firms, and their financing plans are routine. Whether that easy life is in the interests of their stockholders is another matter.
Other firms have to raise capital by selling securities. Naturally, they give careful attention to planning the kinds of securities to be sold and the timing of the offerings. The plan might specify bank borrowing, debt issues, equity issues, or other means to raise capital.
Financial plans help managers ensure that their financing strategies are
consistent with their capital budgets. They highlight the financing decisions
necessary to support the firm’s production and investment goals.
FINANCIAL PLANNING IS NOT JUST FORECASTING
Forecasting concentrates on the most likely future outcome. But financial planners are not concerned solely with forecasting. They need to worry about unlikely events as well as likely ones. If you think ahead about what could go wrong, then you are less likely to ignore the danger signals and you can react faster to trouble.
Companies have developed a number of ways of asking “what-if ” questions about both their projects and the overall firm. Often planners work through the consequences of the plan under the most likely set of circumstances and then use sensitivity analysis to vary the assumptions one at a time. For example, they might look at what would happen if a policy of aggressive growth coincided with a recession. Companies using scenario analysis might look at the consequences of each business plan under different plausible scenarios in which several assumptions are varied at once. For example, one scenario might envisage high interest rates contributing to a slowdown in world economic growth and lower commodity prices. A second scenario might involve a buoyant domestic economy, high inflation, and a weak currency. The nearby box describes how
Georgia Power Company used scenario analysis to help develop its business plans.
THREE REQUIREMENTS FOR EFFECTIVE PLANNING
Forecasting. The firm will never have perfectly accurate forecasts. If it did, there
would be less need for planning. Still, managers must strive for the best forecasts possible.
Forecasting should not be reduced to a mechanical exercise. Naive
extrapolation or fitting trends to past data is of limited value. Planning is
needed because the future is not likely to resemble the past.
Do not forecast in a vacuum. By this we mean that your forecasts should recognize that your competitors are developing their own plans. For example, your ability to implement an aggressive growth plan and increase market share depends on what the competition is likely to do. So try putting yourself in the competition’s shoes and think how they are likely to behave. Of course, if your competitors are also trying to guess your movements, you may need the skills of a good poker player to outguess them. For example, Boeing and Airbus both have schemes to develop new super-jumbo jets. But since there isn’t room for two producers, the companies have been engaging in a game of bluff and counterbluff.
Planners draw on information from many sources. Therefore, inconsistency may be a problem. For example, forecast sales may be the sum of separate forecasts made by many product managers, each of whom may make different assumptions about inflation, growth of the national economy, availability of raw materials, and so on. In such cases, it makes sense to ask individuals for forecasts based on a common set of macroeconomic assumptions.
Choosing the Optimal Financial Plan. In the end, the financial manager has to
choose which plan is best. We would like to tell you exactly how to make this choice.
Unfortunately, we can’t. There is no model or procedure that encompasses all the complexity and intangibles encountered in financial planning.
You sometimes hear managers state corporate goals in terms of accounting numbers.
They might say, “We want a 25 percent return on book equity and a profit margin of 10 percent.” On the surface such objectives don’t make sense. Shareholders want to be richer, not to have the satisfaction of a 10 percent profit margin. Also, a goal that is stated in terms of accounting ratios is not operational unless it is translated back into what that means for business decisions. For example, a higher profit margin can result from higher prices, lower costs, a move into new, high-margin products, or taking over the firm’s suppliers.1 Setting profit margin as a goal gives no guidance about which of
these strategies is best.
So why do managers define objectives in this way? In part such goals may be a mutual exhortation to work harder, like singing the company song before work. But we suspect that managers are often using a code to communicate real concerns. For example, a target profit margin may be a way of saying that in pursuing sales growth the firm has allowed costs to get out of control.
The danger is that everyone may forget the code and the accounting targets may be seen as goals in themselves.
Watching the Plan Unfold. Financial plans are out of date as soon as they are complete. Often they are out of date even earlier. For example, suppose that profits in the first year turn out to be 10 percent below forecast. What do you do with your plan?
Scrap it and start again? Stick to your guns and hope profits will bounce back? Revise down your profit forecasts for later years by 10 percent? A good financial plan should be easy to adapt as events unfold and surprises occur.
Long-term plans can also be used as a benchmark to judge subsequent performance as events unfold. But performance appraisals have little value unless you also take into account the business background against which they were achieved. You are likely to be much less concerned if profits decline in a recession than if they decline when the economy is buoyant and your competitors’ sales are booming. If you know how a downturn is likely to throw you off plan, then you have a standard to judge your performance during such a downturn and a better idea of what to do about it.

Goals of the Corporation

SHAREHOLDERS WANT MANAGERS TO MAXIMIZE MARKET VALUE
For small firms, shareholders and management may be one and the same. But for large companies, separation of ownership and management is a practical necessity. For example, AT&T has over 2 million shareholders. There is no way that these shareholders can be actively involved in management; it would be like trying to run New York City by town meetings. Authority has to be delegated.
How can shareholders decide how to delegate decision making when they all have different tastes, wealth, time horizons, and personal opportunities? Delegation can work only if the shareholders have a common objective. Fortunately there is a natural financial objective on which almost all shareholders can agree. This is to maximize the current value of their investment.
A smart and effective financial manager makes decisions which increase the current value of the company’s shares and the wealth of its stockholders. That increased wealth can then be put to whatever purposes the shareholders want. They can give their money to charity or spend it in glitzy night clubs; they can save it or spend it now. Whatever their personal tastes or objectives, they can all do more when their shares are worth more.
Sometimes you hear managers speak as if the corporation has other goals. For example, they may say that their job is to “maximize profits.” That sounds reasonable.
After all, don’t shareholders want their company to be profitable? But taken literally, profit maximization is not a well-defined corporate objective. Here are three reasons:
1. “Maximizing profits” leaves open the question of “which year’s profits?” The company may be able to increase current profits by cutting back on maintenance or staff training, but shareholders may not welcome this if profits are damaged in future years.
2. A company may be able to increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. That is not in the shareholders’ best interest if the company earns only a very low rate of return on the extra investment.
3. Different accountants may calculate profits in different ways. So you may find that a decision that improves profits using one set of accounting rules may reduce them using another.
In a free economy a firm is unlikely to survive if it pursues goals that reduce the
firm’s value. Suppose, for example, that a firm’s only goal is to increase its market share. It aggressively reduces prices to capture new customers, even when the price discounts cause continuing losses. What would happen to such a firm? As losses mount, it will find it more and more difficult to borrow money, and it may not even have sufficient profits to repay existing debts. Sooner or later, however, outside investors would see an opportunity for easy money. They could offer to buy the firm from its current shareholders and, once they have tossed out existing management, could increase the firm’s value by changing its policies. They would profit by the difference between the price paid for the firm and the higher value it would have under new management. Managers who pursue goals that destroy value often land in early retirement.
We conclude that managers as a general rule will act to maximize the value of
the firm to its stockholders. Management teams that deviate too far from this
rule are likely to be replaced.
ETHICS AND MANAGEMENT OBJECTIVES
We have suggested that managers should try to maximize market value. But some idealists say that managers should not be obliged to act in the selfish interests of their stockholders. Some realists argue that, regardless of what managers ought to do, they in fact look after themselves rather than their shareholders.
Let us respond to the idealists first. Does a focus on value mean that managers must act as greedy mercenaries riding roughshod over the weak and helpless? Most of this book is devoted to financial policies that increase firm value. None of these policies require gallops over the weak and helpless. In most instances there is little conflict between doing well (maximizing value) and doing good.
The first step in doing well is doing good by your customers. Here is how Adam
Smith put the case in 1776:
It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
By striving to enrich themselves and their shareholders, businesspeople have to provide their customers with the products and services they truly desire.
Of course ethical issues do arise in business as in other walks of life. So when we say that the objective of the firm is to maximize shareholder wealth, we do not mean that anything goes.
In part, the law deters managers from blatantly illegal action. But when the stakes are high, competition is intense, and a deadline is looming, it’s easy to blunder, and not to inquire as deeply as they should about the legality or morality of their actions.
Written rules and laws can help only so much. In business, as in other day-to-day affairs, there are also unwritten rules of behavior. These work because everyone knows that such rules are in the general interest. But they are reinforced because good managers know that their firm’s reputation is one of its most important assets and therefore playing fair and keeping one’s word are simply good business practices. Thus huge financial deals are regularly completed on a handshake and each side knows that the other will not renege later if things turn sour.
Reputation is particularly important in financial management. If you buy a well-
known brand in a store, you can be fairly sure what you are getting. But in financial transactions the other party often has more information than you and it is less easy to be sure of the quality of what you are buying. This opens up plenty of opportunities for sharp practice and outright fraud, and, because the activities of rogues are more entertaining than those of honest people, bookshelves are packed with accounts of financial fraudsters.
The reaction of honest financial firms is to build long-term relationships with their customers and establish a name for fair dealing and financial integrity. Major banks and securities firms know that their most valuable asset is their reputation and they emphasize their long history and their responsible behavior when seeking new customers.
When something happens to undermine that reputation the costs can be enormous.
Consider the case of the Salomon Brothers bidding scandal in 1991. A Salomon trader tried to evade rules limiting its participation in auctions of U.S. Treasury bonds by submitting bids in the names of the company’s customers without the customers’ knowledge. When this was discovered, Salomon settled the case by paying almost $200 million in fines and establishing a $100 million fund for payments of claims from civil lawsuits. Yet the value of Salomon Brothers stock fell by far more than $300 million. In fact, the price dropped by about a third, representing a $1.5 billion decline in market value.
Why did the value of the firm drop so dramatically? Largely because investors were worried that Salomon would lose business from customers that now distrusted the company. The damage to Salomon’s reputation was far greater than the explicit costs of the scandal, and hundreds or thousands of times as costly as the potential gains it could have reaped from the illegal trades.
It is not always easy to know what is ethical behavior and there can be many gray areas. For example, should the firm be prepared to do business with a corrupt or repressive government? Should it employ child labor in countries where that is the norm?
The nearby box presents several simple situations that call for an ethically based decision, along with survey responses to the proper course of action in each circumstance.
Compare your decisions with those of the general public.
DO MANAGERS REALLY MAXIMIZE FIRM VALUE?
Owner-managers have no conflicts of interest in their management of the business.
They work for themselves, reaping the rewards of good work and suffering the penalties of bad work. Their personal well-being is tied to the value of the firm.
In most large companies the managers are not the owners and they might be tempted to act in ways that are not in the best interests of the owners. For example, they might buy luxurious corporate jets for their travel, or overindulge in expense-account dinners.
They might shy away from attractive but risky projects because they are worried more about the safety of their jobs than the potential for superior profits. They might engage in empire building, adding unnecessary capacity or employees. Such problems can arise because the managers of the firm, who are hired as agents of the owners, may have their own axes to grind. Therefore they are called agency problems.
Think of the company’s net revenue as a pie that is divided among a number of
claimants. These include the management and the work force as well as the lenders and shareholders who put up the money to establish and maintain the business. The government is a claimant, too, since it gets to tax the profits of the enterprise. It is common to hear these claimants called stakeholders in the firm. Each has a stake in the firm and their interests may not coincide.
All these stakeholders are bound together in a complex web of contracts and understandings. For example, when banks lend money to the firm, they insist on a formal contract stating the rate of interest and repayment dates, perhaps placing restrictions on dividends or additional borrowing. Similarly, large companies have carefully worked out personnel policies that establish employees’ rights and responsibilities. But you can’t devise written rules to cover every possible future event. So the written contracts are supplemented by understandings. For example, managers understand that in return for a fat salary they are expected to work hard and not spend the firm’s money on un-
warranted personal luxuries.
What enforces these understandings? Is it realistic to expect managers always to act on behalf of the shareholders? The shareholders can’t spend their lives watching through binoculars to check that managers are not shirking or dissipating company funds on the latest executive jet.
A closer look reveals several arrangements that help to ensure that the shareholders and managers are working toward common goals.
Compensation Plans. Managers are spurred on by incentive schemes that provide big returns if shareholders gain but are valueless if they do not. For example, when Michael Eisner was hired as chief executive officer (CEO) by the Walt Disney Company, his compensation package had three main components: a base annual salary of $750,000; an annual bonus of 2 percent of Disney’s net income above a threshold of “normal” profitability; and a 10-year option that allowed him to purchase 2 million shares of stock for $14 per share, which was about the price of Disney stock at the time.
Those options would be worthless if Disney’s shares were selling for below $14 but highly valuable if the shares were worth more. This gave Eisner a huge personal stake in the success of the firm.
As it turned out, by the end of Eisner’s 6-year contract the value of Disney shares had increased by $12 billion, more than sixfold. Eisner’s compensation over the period was $190 million. Was he overpaid? We don’t know (and we suspect nobody else knows) how much Disney’s success was due to Michael Eisner or how hard Eisner would have worked with a different compensation scheme. Our point is that managers often have a strong financial interest in increasing firm value. Table 1.4 lists the top-earning CEOs in 1998. Notice the importance of stock options in the total compensation package.
The Board of Directors. Boards of directors are sometimes portrayed as passive supporters of top management. But when company performance starts to slide, and managers don’t offer a credible recovery plan, boards do act. In recent years, the chief executives of IBM, Eastman Kodak, General Motors, and Apple Computer all were forced out. The nearby box points out that boards recently have become more aggressive in their willingness to replace underperforming managers.
If shareholders believe that the corporation is underperforming and that the board of directors is not sufficiently aggressive in holding the managers to task, they can try to replace the board in the next election. The dissident shareholders will attempt to convince other shareholders to vote for their slate of candidates to the board. If they succeed, a new board will be elected and it can replace the current management team.


TABLE 1.4
Highest earning CEOs in 1998

Takeovers. Poorly performing companies are also more likely to be taken over by another firm. After the takeover, the old management team may find itself out on the street.
Specialist Monitoring. Finally, managers are subject to the scrutiny of specialists. Their actions are monitored by the security analysts who advise investors to buy, hold, or sell the company’s shares. They are also reviewed by banks, which keep an eagle eye on the progress of firms receiving their loans.
We do not want to leave the impression that corporate life is a series of squabbles and endless micromanagement. It isn’t, because practical corporate finance has evolved to reconcile personal and corporate interests—to keep everyone working together to increase the value of the whole pie, not merely the size of each person’s slice.
The agency problem is mitigated in practice through several devices:
compensation plans that tie the fortune of the manager to the fortunes of the
firm; monitoring by lenders, stock market analysts, and investors; and
ultimately the threat that poor performance will result in the removal of the
manager.

Who Is the Financial Manager?

We will use the term financial manager to refer to anyone responsible for a significant corporate investment or financing decision. But except in the smallest firms, no single person is responsible for all the decisions discussed in this book. Responsibility is dispersed throughout the firm. Top management is of course constantly involved in financial decisions. But the engineer who designs a new production facility is also involved: the design determines the kind of asset the firm will invest in. Likewise the marketing manager who undertakes a major advertising campaign is making an investment decision: the campaign is an investment in an intangible asset that will pay off in future sales and earnings.
Nevertheless, there are managers who specialize in finance, and their functions are summarized in Figure 1.2. The treasurer is usually the person most directly responsible for looking after the firm’s cash, raising new capital, and maintaining relationships with banks and other investors who hold the firm’s securities.

FIGURE 1.2
The financial managers in
large corporations.

For small firms, the treasurer is likely to be the only financial executive. Larger corporations usually also have a controller, who prepares the financial statements, manages the firm’s internal accounting, and looks after its tax affairs. You can see that the treasurer and controller have different roles: the treasurer’s main function is to obtain and manage the firm’s capital, whereas the controller ensures that the money is used efficiently.
The largest firms usually appoint a chief financial officer (CFO) to oversee both
the treasurer’s and the controller’s work. The CFO is deeply involved in financial policymaking and corporate planning. Often he or she will have general responsibilities beyond strictly financial issues.
Usually the treasurer, controller, or CFO is responsible for organizing and supervising the capital budgeting process. However, major capital investment projects are so closely tied to plans for product development, production, and marketing that managers from these other areas are inevitably drawn into planning and analyzing the projects. If the firm has staff members specializing in corporate planning, they are naturally involved in capital budgeting too.
Because of the importance of many financial issues, ultimate decisions often rest by law or by custom with the board of directors.9 For example, only the board has the legal power to declare a dividend or to sanction a public issue of securities. Boards usually delegate decision-making authority for small- or medium-sized investment outlays, but the authority to approve large investments is almost never delegated.
CAREERS IN FINANCE
In the United States well over 1 million people work in financial services, and many others work in the finance departments of corporations. We can’t tell you what each person does all day, but we can give you some idea of the variety of careers in finance. The nearby box summarizes the experience of a small sample of recent (fictitious) graduates.
We explained earlier that corporations face two principal financial decisions: the investment decision and the financing decision. Therefore, as a newly recruited financial analyst, you may help to analyze a major new investment project. Or you may instead help to raise the money to pay for it, perhaps by a new issue of debt or by arranging to lease the plant and equipment. Other financial analysts work on short-term financial issues, such as collecting and investing the company’s cash or checking whether customers are likely to pay their bills. Financial analysts are also involved in monitoring and controlling risk. For example, they may help to arrange insurance for the firm’s plant and equipment, or they may assist with the purchase and sale of options, futures, and other exotic tools for managing risk.
Instead of working in the finance department of a corporation, you may join a fi-
nancial institution. The largest employers are the commercial banks. We noted earlier that banks collect deposits and relend the cash to corporations and individuals. If you join a bank, at some point you may well work in a branch, where individuals and small businesses come to deposit cash or to seek a loan. Alternatively, you may be employed in the head office, helping to analyze a $100 million loan to a large corporation.
Banks do many things in addition to lending money, and they probably provide a
greater variety of jobs than other financial institutions. For example, individuals and businesses use banks to make payments to each other. So if you work in the cash management department of a large bank, you may help companies electronically transfer huge sums of money as wages, taxes, and payments to suppliers. Banks also buy and sell foreign exchange, so you could find yourself working in front of one of those computer screens in a foreign exchange dealing room. Another glamorous bank job is in the derivatives group, which helps companies to manage their risk by buying and selling options, futures, and so on. This is where the mathematicians and the computer buffs thrive.
Investment banks, such as Merrill Lynch or Goldman Sachs, help companies sell
their securities to investors. They also have large corporate finance departments which assist firms in major reorganizations such as takeovers. When firms issue securities or try to take over another firm, frequently a lot of money is at stake and the firms may need to move fast. Thus, working for an investment bank can be a high-pressure activity with long hours. It can also be very well paid.
The distinction between commercial banks and investment banks is narrowing. For example, commercial banks may also be involved in new issues of securities, while investment banks are major traders in options and futures. Investment banks and commercial banks may even be owned by the same company; for example, Salomon Smith Barney (an investment bank) and Citibank (a commercial bank) are both owned by Citigroup.
The insurance industry is another large employer. Much of the insurance industry is involved in designing and selling insurance policies on people’s lives and property, but businesses are also major customers. So if you work for an insurance company or a large insurance broker, you could find yourself arranging insurance on a Boeing 767 in the United States or an oil rig in Kazakhstan.
A mutual fund collects money from individuals and invests in a portfolio of stocks or bonds. A financial analyst in a mutual fund analyzes the prospects for the securities and works with the investment manager to decide which should be bought and sold.
Many other financial institutions also contain investment management departments. For example, you might work as a financial analyst in the investment department of an insurance company and help to invest the premiums. Or you could be a financial analyst in the trust department of a bank which manages money for retirement funds, universities, and charitable bodies.
Stockbroking firms and bond dealers help investment management companies and private individuals to invest in securities. They employ sales staff and dealers who make the trades. They also employ financial analysts to analyze the securities and help customers to decide which to buy or sell. Many stockbroking firms are owned by investment banks, such as Merrill Lynch.
Investment banks and stockbroking firms are largely headquartered in New York, as are many of the large commercial banks. Insurance companies and investment management companies tend to be more scattered. For example, some of the largest insurance companies are headquartered in Hartford, Connecticut, and many investment management companies are located in Boston. Of course, many financial institutions have large businesses outside the United States. Finance is a global business. So you may spend some time working in a branch overseas or making the occasional trip to one of the other major financial centers, such as London, Tokyo, Hong Kong, or Singapore.
Finance professionals tend to be well paid. Starting salaries for new graduates are in the region of $30,000, rather more in a major New York investment bank and somewhat less in a small regional bank. But let us look ahead a little: Table 1.2 gives you an idea of the compensation that you can look forward to when you become a senior financial manager.

TABLE 1.2
Representative salaries for senior jobs in finance