10 Principles of Basic Financial Management

TEN PRINCIPLES THAT FORM THE BASICS OF FINANCIAL MANAGEMENT Principle 1 The Risk–Return Trade-Off—We Won’t Take On Additional Risk Unless We Expect to Be Compensated with Additional Return At some point we have all saved some money. Why have we done this? The answer is simple: to expand our future consumption opportunities. We are able to invest those savings and earn a return on our dollars because some people would rather borrow money and forgo future consumption opportunities to consume more now. Maybe they’re borrowing money to open a new business, or a company is borrowing money to build a new plant. Assuming there are a lot of different people who would like to use our savings, how do we decide where to put our money? First, for delaying their consumption investors demand a minimum return that must be greater than the anticipated rate of inflation. If they didn’t receive enough to compensate for anticipated inflation, investors would purchase whatever goods they desired ahead of time or invest in assets that were subject to inflation and earn the rate of inflation on those assets. There isn’t much incentive to postpone consumption if your savings are going to decline in terms of their purchasing power, due to inflation. Investment alternatives have different amounts of risk and expected returns. Investors sometimes choose to put their money in risky investments because these investments offer higher expected returns over and above inflation. The more risk an investment has, the higher will be its expected return. This relationship between risk and expected return is shown in Figure 1-2. Notice that we keep referring to expected return rather than actual return. We may have expectations of what the returns from investing will be, but we can’t know for certain. This risk–return relationship is a key concept as we value stocks, bonds, and proposed new projects throughout this text. We also spend some time determining how to measure risk. Interestingly, much of the work for which the 1990 Nobel Prize for Economics was awarded centered on the graph in Figure 1-2 and how to measure risk. Both the graph and the risk–return relationship it depicts reappear often in this text.

Principle 2 The Time Value of Money—A Dollar Received Today Is Worth More Than a Dollar Received in the Future As we mentioned, money has a time value associated with it: A dollar received today is worth more than a dollar received a year from now. Because we can earn interest on money received today, it is better to receive money earlier rather than later. In your economics courses, this concept of the time value of money is referred to as the opportunity cost of passing up the earning potential of a dollar today. In this text, we focus on the creation and measurement of wealth. To measure wealth or value, we use the concept of the time value of money to bring the future benefits and costs of a project back to the present. Then, if the benefits outweigh the costs, the project creates wealth and should be accepted; if the costs outweigh the benefits, the project does not create wealth and should be rejected. Without recognizing the existence of the time value of money, it is impossible to evaluate projects with future benefits and costs in a meaningful way. To bring future benefits and costs of a project back to the present, we must assume a specific opportunity cost of money, or interest rate. Exactly what interest rate to use is determined by Principle 1: The Risk– Return Trade-Off, which states that investors demand higher returns for taking on more risky projects? Thus, when we determine the present value of future benefits and costs, we take into account that investors demand a higher return for taking on added risk.

Principle 3 Cash—Not Profits—Is King In measuring wealth or value we use cash flows, not accounting profits, as our measurement tool. That is, we are concerned with when we have money in hand, when we can invest it and start earning interest on it, and when we can give it back to the shareholders in the form of dividends. Remember, it is cash flows, not profits that are actually received by the firm and can be reinvested. Accounting profits, on the other hand, are shown when they are earned rather than when the money is actually in hand. As a result, a firm’s cash flows and accounting profits may not occur together. For example, capital expenses, such as the purchase of new equipment or a building, are depreciated over several years. Consequently, the annual depreciation subtracted from the firm’s profits occurs only gradually. However, the cash flow associated with this expense generally occurs immediately. Therefore, cash outflows involving paying money out and cash inflows that can be reinvested correctly reflect the timing of the benefits and costs.

Principle 4 Incremental Cash Flows—It’s Only What Changes That Counts In making business decisions, we are concerned with the results of those decisions: What happens if we say yes versus what happens if we say no? Principle 3 states that we should use cash flows to measure the benefits that accrue from taking on a new project. We are now fine-tuning our evaluation process so that we consider only incremental cash flows. The incremental cash flow is the difference between the cash flows if the project is taken on versus what they will be if the project is not taken on. In 2006, when General Mills, the maker of Cheerios, Honey Nut Cheerios, Frosted Cheerios, Apple Cinnamon Cheerios, Berry Burst Cheerios, and Team Cheerios, introduced Yogurt Burst Cheerios—“the lightly sweet flavor of yogurt with the whole grain goodness of Cheerios”—it introduced a product that competed directly with General Mills’ other cereals and, in particular, its Cheerios products. In fact, the Strawberry Yogurt Blast Cheerios, with its strawberry flavor sweetened with yogurt, tastes very much like Berry Burst Strawberry Cheerios. Certainly some of the sales dollars that ended up with Yogurt Burst Cheerios would have been spent on other Cheerios and General Mills’ products if Yogurt Burst Cheerios had not been available. Although General Mills was targeting health conscious consumers with this sweetened cereal, there is no question that Yogurt Burst Cheerios sales bit into—actually cannibalized— sales from Cheerios and other General Mills lines. Realistically, there’s only so much cereal anyone can eat. The difference between revenues General Mills generated after introducing Yogurt Burst Cheerios versus simply maintaining its existing line of cereals is the incremental cash flow. This difference reflects the true impact of the decision. What is important is that we think incrementally. Our guiding rule in deciding whether a cash flow is incremental is to look at the company with and without the new product. In fact, let’s take this incremental concept beyond cash flows and look at all consequences from all decisions on an incremental basis.

Principle 5 The Curse of Competitive Markets—Why It’s Hard to Find Exceptionally Profitable Projects Our job as financial managers is to create wealth. Therefore, we look closely at the mechanics of valuation and decision making. We focus on estimating cash flows, determining what an investment earns, and valuing assets and new projects. However, it is easy to get caught up in the mechanics of valuation and lose sight of the process of creating wealth. Why is it so hard to find projects and investments that are exceptionally profitable? Where do profitable projects come from? The answers to

these questions tell us a lot about how competitive markets operate and where to look for profitable projects. In reality, it is much easier to evaluate profitable projects than find them. If an industry is generating large profits, new entrants are usually attracted. The additional competition is likely to drive profits down to the rate of return investors require. Conversely, if an industry is returning profits below the “required” rate of return, then some participants in the market drop out, reducing supply and competition. In return, prices are driven back up. This is precisely what happened in the VCR video rental market in the mid-1980s. This market developed suddenly with the opportunity for extremely large profits. Because there were no barriers to entry, the market quickly was flooded with new entries. By 1987 the competition and price cutting produced losses for many firms in the industry, forcing them to flee the market. As the competition lessened and firms moved out of the video rental industry, profits again rose to the point at which the required rate of return could be earned on invested capital. In competitive markets, extremely large profits simply cannot exist for very long. Given that somewhat bleak scenario, how can we find good projects—that is, projects that return more than their expected rate of return given their risk level (remember Principle 1)? Although competition makes them difficult to find, we have to invest in markets that are not perfectly competitive. The two most common ways of making markets less competitive are to differentiate the product in some key way and to achieve a cost advantage over one’s competitors. If products are differentiated, the consumer’s choice is no longer made on the basis of price alone. For example, many people are willing to pay a premium for Starbucks coffee. They simply want Starbucks and price is not important. In the pharmaceutical industry, patents create competitive barriers. For example, Hoffman–La Roche’s Valium, a tranquilizer, is protected from direct competition by patents. Service and quality are also used to differentiate products. For example, Levi’s has long prided itself on the quality of its jeans. As a result, it has been able to maintain its market share. Similarly, much of Toyota’s and Honda’s brand loyalty is based on quality. Service can also create product differentiation, as shown by McDonald’s fast service, cleanliness, and consistency of product, which bring customers back. Whether product differentiation occurs because of advertising, patents, service, or quality, the more the product is differentiated from competing products, the less competition it will face and the greater the possibility of large profits. Economies of scale and the ability to produce at a cost below competition can effectively deter new entrants to the market and thereby reduce competition. Wal-Mart is one such case. For Wal-Mart, the fixed costs are largely independent of the store’s size. For example, inventory costs, advertising expenses, and managerial salaries are essentially the same regardless of annual sales. Therefore, the more sales that can be built up, the lower the per sale dollar cost of inventory, advertising, and management. Restocking from warehouses also becomes more efficient because delivery trucks can be used to full potential.

Regardless of how the cost advantage is created—by economies of scale, proprietary technology, or monopolistic control of raw materials—it deters new market entrants willowing production at below industry cost. This cost advantage has the potential of creating large profits. The key to locating profitable investment projects is to first understand how and where they exist in competitive markets. Then the corporate philosophy must be aimed at creating or taking advantage of some imperfection in these markets, through either product differentiation or creation of a cost advantage, rather than looking to new markets or industries that appear to provide large profits. Any perfectly competitive industry that looks too good to be true won’t be for long. It is necessary to understand this to know where to look for good projects and to accurately measure the project’s cash flows. We can do this better if we recognize how wealth is created and how difficult it is to create.

Principle 6 Efficient Capital Markets—The Markets Are Quick and the Prices Are Right As we have said, our goal as financial managers is the maximization of shareholder wealth. But how do we measure shareholder wealth? It is the value of all the shares that the share-holders own. To understand what causes stocks to change in price, as well as how securities such as bonds and stocks are valued or priced in the financial markets, it is necessary to have an understanding of the concept of efficient markets. These are markets in which the values of all assets and securities at any instant in time fully reflect all available information. Whether a market is efficient has to do with the speed with which information is impounded into security prices. An efficient market is characterized by a large number of profit-driven individuals who act independently. In addition, new information regarding securities arrives in the market in a random manner. Given this setting, investors adjust to new information immediately and buy and sell a security until they feel the market price correctly reflects the new information. In efficient markets information is reflected in security prices with such speed that there are no opportunities for investors to profit from publicly available information. Investors competing for profits ensure that security prices appropriately reflect the expected earnings and risks involved and, thus, the true value of the firm. What are the implications of efficient markets for us? First, the price is right. Stock prices reflect all publicly available information regarding the value of the company. This means we can implement our goal of maximization of shareholder wealth by focusing on the effect each decision should have on the stock price if everything else is held constant. That is, over time good decisions result in higher stock prices and bad ones in lower stock prices. Accounting changes, for example, do not result in price changes because they do not affect cash flows. Rather, market prices reflect the expected cash flows available to shareholders. Thus, our preoccupation with cash flows to measure the timing of the benefits is justified. As we will see, it is indeed reassuring that prices reflect value. It allows us to look at prices and see value reflected in them. Although it may make investing a bit less exciting, it makes corporate finance much less uncertain.

Principle 7 The Agency Problem—Managers Won’t Work for the Firm’s Owners Unless It’s in Their Best Interest Although the goal of the firm is the maximization of shareholder wealth, in reality the agency problem may interfere with the implementation of this goal. The agency problem results from the separation of the management and the ownership of the firm. To begin with, an agent is someone who is given the authority to act on behalf of another, who is referred to as the principal. In the corporate setting, the shareholders are the principals, because they are the actual owners of the firm. The board of directors, the CEO, the corporate executives, and all others with decision-making power are agents of the share-holders. Because of this separation of the decision makers and owners, managers may make decisions that are not in line with the goal of maximizing shareholder wealth. They may approach work less energetically and attempt to benefit themselves in terms of their salaries and “perks” at the expense of shareholders. The firm’s top managers might also avoid any projects that have risk associated with them—even if they’re great projects with huge potential returns and a small chance of failure. Why is this so? Because if the project doesn’t turn out, these agents of the shareholders may lose their jobs. The costs associated with the agency problem are difficult to measure, but occasionally we see the problem’s effect in the marketplace. For example, if the market feels the management of a firm is

damaging shareholder wealth, we might see a positive reaction in the stock price following the removal of that management. In 2005, on the announcement of the death of Roy Farmer, the CEO of Farmer Brothers, a seller of coffee-related products, Farmer Brothers’ stock price rose about 28 percent. Generally, the tragic loss of a company’s top executive raises concerns over a leadership void, causing the share price to drop, but in the case of Farmer Brothers, investors thought a change in management would have a positive impact on the company. If the managers of the firm work for the owners, who are the shareholders, why don’t the managers get fired if they don’t act in the shareholders’ best interest? In theory, the share-holders pick the corporate board of directors and the board of directors in turn picks the managers. Unfortunately, in reality the system frequently works the other way around. Managers select the board of director nominees and then distribute the ballots. In effect, share-holders are offered a slate of nominees selected by the management. The end result is that the directors may have more allegiance to the managers than to shareholders. This in turn sets up the potential for agency problems, with the board of directors not monitoring managers on behalf of the shareholders as they should. We spend considerable time discussing monitoring managers and trying to align their interests with shareholders. The interests of managers and shareholders can be aligned by establishing management stock options, bonuses, and perquisites that are directly tied to how closely their decisions coincide with the interest of shareholders. The agency problem will persist unless an incentive structure is set up that aligns the interests of managers and shareholders. In other words, what is good for shareholders must also be good for managers. If that is not the case, managers will make decisions in their own best interest rather than maximizing shareholder wealth.

Principle 8 Taxes Bias Business Decisions Hardly any decision is made by the financial manager without considering the impact of taxes. When we introduced Principle 4, we said that only incremental cash flows should be considered in the evaluation process. More specifically, the cash flows we consider are the after-tax incremental cash flows to the firm as a whole. When we evaluate new projects, we will see income taxes play a significant role. For example, when the company is analyzing the possible acquisition of a plant or equipment, the returns from the investment should be measured on an after-tax basis. Otherwise, the company is not evaluating the true incremental cash flows generated by the project. The government also realizes taxes can bias business decisions and uses taxes to encourage spending in certain ways. If the government wants to encourage spending on research and development projects, it might offer an investment tax credit for such investments. This would have the effect of reducing taxes on research and development projects, which would in turn increase the after-tax cash flows from those projects. The increased cash flow would turn some otherwise unprofitable research and development projects into profitable projects. In effect, the government can use taxes as a tool to direct business investment to research and development projects, to the inner cities, and to projects that create jobs.

Principle 9 All Risk Is Not Equal—Some Risk Can Be Diversified Away, and Some Can Not Much of finance centers around Principle 1, the Risk–Return Trade-Off. But before we can fully use Principle 1, we must decide how to measure risk. As we will see, risk is difficult to measure. Principle 9 introduces you to the process of diversification and demonstrates how it can reduce risk. We also provide you with an understanding of how diversification makes it difficult to measure a project’s or an asset’s risk. You are probably already familiar with the concept of diversification. There is an old saying, “don’t put all your eggs in one basket.” Diversification allows good and bad events to cancel each other out, thereby reducing the total variability of a project, or investment, without affecting its expected return. To see how diversification complicates the measurement of risk, let’s look at the difficulty Louisiana Gas has in determining the level of risk associated with a new natural gas well-drilling project. Each year Louisiana Gas might drill several hundred wells, with each well having only a 1 in 10 chance of success. If the well produces, the profits are quite large, but if it comes up dry, the investment is lost. Thus, with a 90 percent chance of losing everything, we would view the project as being extremely risky. However, if each year Louisiana Gas drills 2,000 wells, all with a 10 percent, independent chance of success, then it would typically have 200 successful wells. Moreover, a bad year may result in only 190 successful wells, whereas a good year may result in 210 successful wells. If we look at all the wells together, the extreme good and the bad results tend to cancel each other out and the well drilling projects taken together do not appear to have much risk or variability of possible outcome. The amount of risk in a gas well project depends on our perspective. Looking at the well standing alone, it looks like a lot of risk. However, if we consider the risk that each well contributes to the overall firm risk, it is quite small. This occurs because much of the risk associated with each individual well is diversified away within the firm. The point is we can’t look at a project in isolation. Later, we will see that some of this risk can be further diversified away within the shareholder’s portfolio. Perhaps the easiest way to understand the concept of diversification is to look at it graphically. Consider what happens when we combine two projects, as depicted in Figure 1-3. In this case, the cash flows from these projects move in opposite directions, but when they are combined, the variability of their combination is totally eliminated. Notice that the return has not changed—both the individual projects’ returns and their combination’s return average 10 percent. In this case the extreme good and bad observations cancel each other out. The degree to which the total risk is reduced is a function of how the two sets of cash flows or returns from the projects move together. As we will see for most projects and assets, some risk can be eliminated through diversification, whereas some risk cannot. This becomes an important distinction later in our studies. For now, we should realize that the process of diversification can reduce risk, and as a result, measuring a project’s or an asset’s risk is very difficult. A project’s risk changes depending on whether you measure it standing alone or together with other projects the company may take on.

Principle 10 Ethical Behavior Means Doing the Right Thing, but Ethical Dilemmas Are Everywhere in Finance Ethical behavior means “doing the right thing.” The difficulty arises, however, in attempting to define “doing the right thing.” The problem is that each of us has his or her own set of values, which forms the basis for our personal judgments about what is the right thing to do. However, every society adopts a set of rules or laws that prescribe what it believes to be “doing the right thing.” In a sense, we can think of laws as a set of rules that reflect the values of the society as a whole, as they have evolved. For purposes of this text, we recognize that people have a right to disagree about what constitutes “doing the right thing,” and we seldom venture beyond the basic notion that ethical conduct involves abiding by society’s rules. However, we point out some of the ethical dilemmas that have arisen in recent years with regard to the practice of financial management. So as we embark on our study of finance and encounter ethical dilemmas, we encourage you to consider the issues and form your own opinions. Many students ask, “Is ethics really relevant?” This is a good question and deserves an answer. First, although business errors can be forgiven, ethical errors tend to end careers and terminate future opportunities. Why? Because unethical behavior eliminates trust, and without trust businesses cannot interact. Second, the most damaging event a business can experience is a loss of the public’s confidence in its ethical standards. In finance we have seen several recent examples of such events. Ethics, or rather a lack of ethics, in finance is a recurring theme in the news. Scandals like those at Salomon Brothers, Enron, WorldCom, and Tyco seem to make continuous headlines. But as the lessons of these companies illustrate, ethical errors are not forgiven in the business world. Not only is acting in an ethical manner morally correct, but also it is congruent with our goal of maximization of shareholder wealth. Beyond the question of ethics is the question of social responsibility. In general, corporate social responsibility means that a corporation has responsibilities to society beyond the maximization of shareholder wealth. It asserts that a corporation answers to a broader constituency than its shareholders alone. As with most debates that center on ethical and moral questions, there is no definitive answer. One opinion is that because financial managers are employees of the corporation and the corporation is owned by the shareholders, the financial managers should run the corporation in such a way that shareholder wealth is maximized and then allow the shareholders to decide if they would like to fulfill a sense of social responsibility by passing on any of the profits to deserving causes. Very few corporations consistently act in this way. For example, Bristol-Myers Squibb Co. has an ambitious program to give away heart medication to those who cannot pay for it. This program came in the wake of an American Heart Association report showing that many of the nations’ working poor face severe health risks because they cannot afford such medications. Clearly, Bristol-Myers Squibb felt it had a social responsibility to provide this medicine to the poor at no cost. How do you feel about this decision?