To carry on business, companies need an almost endless variety of real assets. Many of these assets are tangible, such as machinery, factories, and offices; others are intangible, such as technical expertise, trademarks, and patents. All of them must be paid for.
To obtain the necessary money, the company sells financial assets, or securities. These pieces of paper have value because they are claims on the firm’s real assets and the cash that those assets will produce. For example, if the company borrows money from the bank, the bank has a financial asset. That financial asset gives it a claim to a stream of interest payments and to repayment of the loan. The company’s real assets need to produce enough cash to satisfy these claims.
Financial managers stand between the firm’s real assets and the financial markets in which the firm raises cash. The financial manager’s role is shown in Figure 1.1, which traces how money flows from investors to the firm and back to investors again.
The flow starts when financial assets are sold to raise cash (arrow 1 in the figure). The cash is employed to purchase the real assets used in the firm’s operations (arrow 2).
Later, if the firm does well, the real assets generate enough cash inflow to more than repay the initial investment (arrow 3). Finally, the cash is either reinvested (arrow 4a) or returned to the investors who contributed the money in the first place (arrow 4b). Of course the choice between arrows 4a and 4b is not a completely free one. For example, if a bank lends the firm money at stage 1, the bank has to be repaid this money plus interest at stage 4b.
This flow chart suggests that the financial manager faces two basic problems. First, how much money should the firm invest, and what specific assets should the firm invest in? This is the firm’s investment, or capital budgeting, decision. Second, how should the cash required for an investment be raised? This is the financing decision.
THE CAPITAL BUDGETING DECISION
Capital budgeting decisions are central to the company’s success or failure. For example, in the late 1980s, the Walt Disney Company committed to construction of a Disneyland Paris theme park at a total cost of well over $2 billion. The park, which opened in 1992, turned out to be a financial bust, and Euro Disney had to reorganize in May 1994. Instead of providing profits on the investment, accumulated losses on the park by that date were more than $200 million.
Contrast that with Boeing’s decision to “bet the company” by developing the 757 and 767 jets. Boeing’s investment in these planes was $3 billion, more than double the total value of stockholders’ investment as shown in the company’s accounts at the time. By 1997, estimated cumulative profits from this investment were approaching $8 billion, and the planes were still selling well.
Disney’s decision to invest in Euro Disney and Boeing’s decision to invest in a new generation of airliners are both examples of capital budgeting decisions. The success of such decisions is usually judged in terms of value. Good investment projects are worth more than they cost. Adopting such projects increases the value of the firm and therefore the wealth of its shareholders. For example, Boeing’s investment produced a stream of cash flows that were worth much more than its $3 billion outlay.
Not all investments are in physical plant and equipment. For example, Gillette spent around $300 million to market its new Mach3 razor. This represents an investment in a nontangible asset—brand recognition and acceptance. Moreover, traditional manufacturing firms are not the only ones that make important capital budgeting decisions. For example, Intel’s research and development expenditures in 1998 were more than $2.5 billion. This investment in future products and product improvement will be crucial to the company’s ability to retain its existing customers and attract new ones.
Today’s investments provide benefits in the future. Thus the financial manager is
concerned not solely with the size of the benefits but also with how long the firm must wait for them. The sooner the profits come in, the better. In addition, these benefits are rarely certain; a new project may be a great success—but then again it could be a dismal failure. The financial manager needs a way to place a value on these uncertain future benefits.
We will spend considerable time in later material on project evaluation. While no one can guarantee that you will avoid disasters like Euro Disney or that you will be blessed with successes like the 757 and 767, a disciplined, analytical approach to project proposals will weight the odds in your favor.
THE FINANCING DECISION
The financial manager’s second responsibility is to raise the money to pay for the investment in real assets. This is the financing decision. When a company needs financing, it can invite investors to put up cash in return for a share of profits or it can promise investors a series of fixed payments. In the first case, the investor receives newly issued shares of stock and becomes a shareholder, a part-owner of the firm. In the second, the investor becomes a lender who must one day be repaid. The choice of the longterm financing mix is often called the capital structure decision, since capital refers to the firm’s sources of long-term financing, and the markets for long-term financing are called capital markets. Within the basic distinction—issuing new shares of stock versus borrowing money —there are endless variations. Suppose the company decides to borrow. Should it go to capital markets for long-term debt financing or should it borrow from a bank? Should it borrow in Paris, receiving and promising to repay euros, or should it borrow dollars in New York? Should it demand the right to pay off the debt early if future interest rates fall?
The decision to invest in a new factory or to issue new shares of stock has long-term consequences. But the financial manager is also involved in some important short-term decisions. For example, she needs to make sure that the company has enough cash on hand to pay next week’s bills and that any spare cash is put to work to earn interest. Such short-term financial decisions involve both investment (how to invest spare cash) and financing (how to raise cash to meet a short-term need).
Businesses are inherently risky, but the financial manager needs to ensure that risks are managed. For example, the manager will want to be certain that the firm cannot be wiped out by a sudden rise in oil prices or a fall in the value of the dollar. We will look at the techniques that managers use to explore the future and some of the ways that the firm can be protected against nasty surprises.
To obtain the necessary money, the company sells financial assets, or securities. These pieces of paper have value because they are claims on the firm’s real assets and the cash that those assets will produce. For example, if the company borrows money from the bank, the bank has a financial asset. That financial asset gives it a claim to a stream of interest payments and to repayment of the loan. The company’s real assets need to produce enough cash to satisfy these claims.
Financial managers stand between the firm’s real assets and the financial markets in which the firm raises cash. The financial manager’s role is shown in Figure 1.1, which traces how money flows from investors to the firm and back to investors again.
The flow starts when financial assets are sold to raise cash (arrow 1 in the figure). The cash is employed to purchase the real assets used in the firm’s operations (arrow 2).
Later, if the firm does well, the real assets generate enough cash inflow to more than repay the initial investment (arrow 3). Finally, the cash is either reinvested (arrow 4a) or returned to the investors who contributed the money in the first place (arrow 4b). Of course the choice between arrows 4a and 4b is not a completely free one. For example, if a bank lends the firm money at stage 1, the bank has to be repaid this money plus interest at stage 4b.
This flow chart suggests that the financial manager faces two basic problems. First, how much money should the firm invest, and what specific assets should the firm invest in? This is the firm’s investment, or capital budgeting, decision. Second, how should the cash required for an investment be raised? This is the financing decision.
FIGURE 1.1
Flow of cash between capital markets and the firm’s
operations. Key: (1) Cash raised by selling financial
assets to investors; (2) cash invested in the firm’s
operations; (3) cash generated by the firm’s
operations; (4a) cash reinvested; (4b) cash
returned to investors.
Flow of cash between capital markets and the firm’s
operations. Key: (1) Cash raised by selling financial
assets to investors; (2) cash invested in the firm’s
operations; (3) cash generated by the firm’s
operations; (4a) cash reinvested; (4b) cash
returned to investors.
THE CAPITAL BUDGETING DECISION
Capital budgeting decisions are central to the company’s success or failure. For example, in the late 1980s, the Walt Disney Company committed to construction of a Disneyland Paris theme park at a total cost of well over $2 billion. The park, which opened in 1992, turned out to be a financial bust, and Euro Disney had to reorganize in May 1994. Instead of providing profits on the investment, accumulated losses on the park by that date were more than $200 million.
Contrast that with Boeing’s decision to “bet the company” by developing the 757 and 767 jets. Boeing’s investment in these planes was $3 billion, more than double the total value of stockholders’ investment as shown in the company’s accounts at the time. By 1997, estimated cumulative profits from this investment were approaching $8 billion, and the planes were still selling well.
Disney’s decision to invest in Euro Disney and Boeing’s decision to invest in a new generation of airliners are both examples of capital budgeting decisions. The success of such decisions is usually judged in terms of value. Good investment projects are worth more than they cost. Adopting such projects increases the value of the firm and therefore the wealth of its shareholders. For example, Boeing’s investment produced a stream of cash flows that were worth much more than its $3 billion outlay.
Not all investments are in physical plant and equipment. For example, Gillette spent around $300 million to market its new Mach3 razor. This represents an investment in a nontangible asset—brand recognition and acceptance. Moreover, traditional manufacturing firms are not the only ones that make important capital budgeting decisions. For example, Intel’s research and development expenditures in 1998 were more than $2.5 billion. This investment in future products and product improvement will be crucial to the company’s ability to retain its existing customers and attract new ones.
Today’s investments provide benefits in the future. Thus the financial manager is
concerned not solely with the size of the benefits but also with how long the firm must wait for them. The sooner the profits come in, the better. In addition, these benefits are rarely certain; a new project may be a great success—but then again it could be a dismal failure. The financial manager needs a way to place a value on these uncertain future benefits.
We will spend considerable time in later material on project evaluation. While no one can guarantee that you will avoid disasters like Euro Disney or that you will be blessed with successes like the 757 and 767, a disciplined, analytical approach to project proposals will weight the odds in your favor.
THE FINANCING DECISION
The financial manager’s second responsibility is to raise the money to pay for the investment in real assets. This is the financing decision. When a company needs financing, it can invite investors to put up cash in return for a share of profits or it can promise investors a series of fixed payments. In the first case, the investor receives newly issued shares of stock and becomes a shareholder, a part-owner of the firm. In the second, the investor becomes a lender who must one day be repaid. The choice of the longterm financing mix is often called the capital structure decision, since capital refers to the firm’s sources of long-term financing, and the markets for long-term financing are called capital markets. Within the basic distinction—issuing new shares of stock versus borrowing money —there are endless variations. Suppose the company decides to borrow. Should it go to capital markets for long-term debt financing or should it borrow from a bank? Should it borrow in Paris, receiving and promising to repay euros, or should it borrow dollars in New York? Should it demand the right to pay off the debt early if future interest rates fall?
The decision to invest in a new factory or to issue new shares of stock has long-term consequences. But the financial manager is also involved in some important short-term decisions. For example, she needs to make sure that the company has enough cash on hand to pay next week’s bills and that any spare cash is put to work to earn interest. Such short-term financial decisions involve both investment (how to invest spare cash) and financing (how to raise cash to meet a short-term need).
Businesses are inherently risky, but the financial manager needs to ensure that risks are managed. For example, the manager will want to be certain that the firm cannot be wiped out by a sudden rise in oil prices or a fall in the value of the dollar. We will look at the techniques that managers use to explore the future and some of the ways that the firm can be protected against nasty surprises.
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