Chapter 1

CHAPTER 1 An Overview of Finance

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B ox 1.1 A Question of Ethics: Levi Strauss & Co. and Child Labor

In 1992 Levi Strauss was confronted with a difficult problem. Two of its subcontractors in Bangladesh were using child labor. Its first response was to consider ordering the subcontractor to fire the children and replace them with adult workers. On further investigation, Levi learned that if the children lost their jobs, they would probably be driven into prostitution to help support their families. Levi recognized that not only did the managers face an ethical dilemma, but there could be a public relations disaster if the press publicized the fact that they employed children. The dilemma: Lay off the children and force them into prostitution or keep them working at the factories, thereby contributing to child labor and opening the company up to bad publicity

The solution Levi arrived at was both unusual and innovative. The children were taken out of the factories and Levi continued to pay their wages as long as they attended school full time. Levi guaranteed the children factory jobs

upon reaching age 14, the local age of maturity. This solution benefited Levi in several ways. First, the risk of bad publicity was replaced with a conspicuous display of decency. Second, Levi began preparing a more qualified and better-educated workforce for the future. Finally, because the children had to attend school to get their wages, the families could be counted on to keep them in school—an important issue in a country where education is not strongly supported.

Innovative solutions to ethical problems such as these will be required in the future as the shareholder wealth maximization goal conflicts with social consciousness. Let us hope that managers will take the time and trouble to find appropriate solutions.

ing the stock price, Iacocca became a very wealthy man. This deal served shareholders very well.

At times, firm managers are caught in a position where their own personal ethics and social consciousness are at odds with the wealth maximization goal. For example, should a firm allow child labor in countries where it is legal and is the lowest-cost method of production? Box 1.1 describes how Levi Strauss & Co. dealt with this problem. Managers may need to be creative to find solutions to difficult problems such as this so that shareholders, managers, and the public are satisfied.

What About Bondholders?

Before we leave our discussion of the financial manager's goal, let us review what this goal means to the firm's bondholders. Bondholders lend money to the firm and are paid interest until the debt matures and they are paid back the principal. If managers are to maximize stockholder wealth, do they care about bondholders' wealth? Bondholders do not elect directors, set managers' salaries, or otherwise directly affect managers' welfare. To the extent that this is true, managers will not work very hard to make the bondholder happy. In fact, the wealth maximization goal suggests that the manager would be willing to take wealth away from the bondholder and give it to the stockholder.

Suppose it were possible for managers to set up a new company, sell bonds to the public, immediately distribute the proceeds to shareholders by declaring a dividend, and then file for bankruptcy. Certainly this transaction would please shareholders, but if this happened often, bonds would become impossible to sell. This explains why bondholders demand protection in the form of long, written agreements that constrain managers.

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A typical provision prevents the firm from paying a dividend unless the firm meets certain cash flow requirements. Because managers already are looking out for them, shareholders do not need to be protected by these written agreements.

Self-Test Review Questions*

1.What is the goal of the financial manager?

2.Give three reasons why profit maximization is not a good goal.

3.Why would managers fail to maximize shareholder wealth?

4.Are managers likely to spend much energy looking out for bondholders?

Study Tip

The distinction between required, expected, and actual returns can be confusing. The required return is what you need to be satisfied. The expected return is what you think you will get. The actual return is what you actually receive. If you expect a security to pay more than you require, you will buy it.

FIVE KEY CONCEPTS OF FINANCE

This textbook covers many areas of finance. The lessons may be applied to nearly every aspect of our lives. This may suggest that it contains many unrelated topics, but this is not the case. A few basic concepts reappear throughout the text that help direct our study of the topic at hand. This section summarizes these concepts. We will initially assume that they are true and call them maxims, meaning an established principle or general truth. Later, we will see that there are shades of truth, and that even these fundamental concepts are subject to some controversy.

Greater Returns Require Taking Greater Risk

This assumption is at the heart of individual behavior. Before giving up consumption today, an investor will demand greater consumption in the future. Economists call the additional amount of consumption demanded the real rate of interest. It is independent of inflation. If I offer you the option of receiving a new pair of shoes today or next year, you are most likely to choose to receive them today. Wanting things now is part of human nature. I will have to offer you more in the future to induce you to delay consumption. For example, if I offer you the choice between a pair of shoes now or a pair of shoes plus a pair of socks next year and the socks are the minimum required to induce you to wait, then they represent your real rate of return. Real rates are expressed as percentages rather than as clothing accessories. This real rate is the minimum acceptable return, and it is based purely on human nature. We simply like to have things now rather than later.

However, if investors want something more than the real rate of return, they must incur more risk. Figure f .3 shows the relationship between risk and return. They-inter- cept is at the risk-free rate (the rate you can earn without incurring any chance of loss). As the level of risk increases, the required return increases. The required return is the

CHAPTER 1 An Overview of Finance

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minimum return needed to make the investor feel properly compensated for taking on additional risk.

Why does the risk-return line slope upward? Suppose an investor wants to save for the future. It is natural that this investor will choose the least risky investment available. However, there are securities for sale that have various amounts of risk. The only way that sellers of risky securities can entice an investor to buy these securities is to offer a higher interest rate. The seller will raise the return to the investor until the securities sell. Investors demand more return to compensate for the greater risk. If the return on assets did not fluctuate with risk, no one would be willing to buy riskier securities. As a result, not all of the securities in the market would sell.

Do higher-risk investments always provide higher returns? Absolutely not! If we knew what the return was going to be, the investment would not really be risky. When an investor buys a risky security, the required return is high. The actual return may indeed be equal to the expected return, or it may be even more. It also may be much less.

Investments are always made based on expected returns. The expected return is what investors think the future return will be. If they expect more than they require, they will buy the stock. Investment analysts make their living attempting to project future stock returns. We will pursue this topic further in Chapter 7.

The risk-return assumption can be summarized as follows:

Finance Maxim 1: Investors will not delay consumption unless they expect to get something extra in return, nor will they incur risk without being compensated for that risk.

Good Deals Disappear Fast

Suppose a new employee at Nordstrom's Department Store misunderstands the manager and, rather than putting last year's unsold merchandise out for sale, drastically reduces the price on a new shipment of Tommy Hilfiger shirts. Shoppers would quickly buy the

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shirts. Who would be able to take advantage of this good deal? Only shoppers who knew what the true price of the shirts should be and who happened to spot the bargain. Every shopper is looking for the same thing—good deals—but which shoppers are most likely to find them? The good deals go to those who know prices well enough to recognize a deal when it surfaces and to those who find it first.

The same situation exists in the securities markets. Every investor is looking for the same thing: a good deal. Good deals may occasionally surface. Who will be able to take advantage of them? The answer to this question leads to our next finance maxim.

Finance Maxim 2: Good deals go to the investor who is able to recognize them and reacts first.

For example, big investment fund companies employ a number of specialists who spend all of their time studying a few stocks or industries. When news about one of these stocks or industries is released, the mutual fund specialists can quickly buy or sell the affected security. Because the investment company controls large amounts of money the price of the security will move quickly, and the opportunity for big returns disappears.

Consider this simplified example. In October 1995 China's leading car maker picked General Motors Corp. over Ford Motor Co. for a project valued at more than $1 billion to build sedans in China. General Motors stock was then selling at $44.50 per share and earnings per share (EPS) were $7.43. If GM distributed all of the earnings to the shareholders, the return would have been

If analysts projected that earnings per share would increase to $7.75 because of the deal with China, the projected return would increase to 17.42%:

If a return of 16.70%, as it was before the announcement, was adequate given the risk of this stock, then General Motors stock represented a good deal at $44.50, and analysts would have issued buy orders. The demand for millions of shares of the stock would cause its price to rise. Theoretically, investors would continue to buy shares until the price rose to the point where the return was again 16.70%. This happens when the stock price is $46.42:

As new information becomes available to investors, security prices will adjust so that the return to investors is fair. Millions of investors are looking for mispriced securities every day. Many of these investors control large amounts of money that they can direct into good deals. As these securities are bought or sold, the prices move up or down until the good deal is gone. Exactly how quickly and accurately security prices reflect

CHAPTER 1 An Overview of Finance	15
news is the subject of a tremendous amount of research and debate. We say that markets
that do a good job of pricing securities are efficient. Few argue the logic behind efficient
markets, but many disagree as to exactly how efficient the markets actually are.
What are the implications of efficient markets? If the markets were really able to
assign the true intrinsic price to every security and investment offered for sale, every
investment would be fair. It would not matter how the investor selected assets for a port-
folio. A monkey throwing darts at the Wall Street Journal could pick stocks as well as the
most learned professional. Obviously, the learned professional is not going to accept this
idea easily. Chapter 9 discusses market efficiency in greater depth.
The concept of market efficiency can be summarized as follows: If financial markets
are efficient, the price of a security is an accurate estimate by the market of its true alue.

The Value of Money Depends on When

It Is Received

Which would you rather have: $ 100 right now or $ 100 in 1 year? This is an easy choice. Even if you do not need the $100 now, you could invest it so that more would be available in a year. People pay more for things they prefer, so if investors prefer cash flows now rather than later, current cash flows are more valuable. The longer it will be before a cash flow arrives, the less valuable it becomes.

Much of the math we do in this course revolves around adjusting the value of cash flows to compensate for when they arrive. The value of assets depends on when the cash flows generated by the assets arrive. Investment opportunities depend on whether the values of future cash flows are greater than the initial investment. To make these calculations, we must recognize that the interest rate the initial investment could have earned is an opportunity cost. The higher the risk of the future cash flows, the greater the required return (remember the risk-return assumption) and the higher the interest rate.

Another way of looking at why we must adjust for when cash flows arrive is to consider what happens when we make an investment. Investors spend money today hoping that they will receive funds in the future. To decide whether the investment should be made, the investor compares what is being spent with what will be received. How can investors make this comparison if they receive the dollars at different points in time? Because the dollars have different values depending on when they are received, comparing dollars without adjusting for time is like comparing dollars with pesos without adjusting for the exchange rate.

We can summarize our third finance maxim, the time value of money concept, as follows:

Finance Maxim 3: A dollar received today is worth more than a dollar received in the future.

Cash Is King

In finance, cash flows are what matter, not accounting earnings or profits. This is because cash flows are what investors can invest and firms can use to pay dividends.

16	PART I Markets and Institutions

Accountants report earnings when they are earned, not when they are received. Because accounting profits cannot be invested or used to pay dividends, we must deal with cash. Another reason we deal with cash flows rather than accounting profits is that financial calculations always consider the exact timing of the cash flows and adjust for the time value of money. Accounting profits often have little to do with when funds will actually be received or spent.

The major difference between cash flows and accounting profits is how asset purchases are treated. Accountants depreciate an asset over its useful life. The financial analyst deducts the entire cost of an asset during the period when the firm buys it because that is when the cash expenditure takes place. Unfortunately, one problem with this adjustment is that firms pay taxes according to the accountant's way of recording asset purchase expenses. This requires that we compute taxes one way and report cash flows another. We will learn how this is done in Chapter 11.

Our fourth finance maxim, the concept that cash is king, can be stated as follows:

Finance Maxim 4: Cash flows determine value.

Not Everyone Knows the Same Things

In a business context, asymmetric information refers to the fact that not everyone knows everything. Investors may not know what the firm's insiders know. A bank may not know what a borrower plans to do with a loan. An insurance agent may not know how well an insured person will act to protect against loss. Each of these examples represents an opportunity for one party to gain at the expense of the other.

Consider Gina Day, owner of Rockies Brewing Co., a microbrewery located in Boulder, Colorado. During the first several years, she tried to convince investors that her firm was doing well and would provide excellent returns. Unfortunately, firm managers have no credibility with the public because they have an incentive to stretch the truth. Rockies Brewing Co. has survived and has grown by 1,000% since 1990. Too bad investors did not believe her!

The asymmetric information problem explains many events in finance. When a firm announces that it is going to borrow, the stock price usually rises. This is because investors believe that if management issues debt it is signaling the firm's ability to meet the required cash flows far into the future. Similarly, when it sells new stock, management is signaling that the stock is overpriced, so stock prices, on average, drop. Asymmetric information can explain many different financial events, such as why there are protective covenants and why firms may pay a dividend while simultaneously borrowing money. We will point out these issues as they arise later in the text.

In summary, our fifth finance maxim is as follows:

Finance Maxim 5: Asymmetric information is the difference in the information set held by different participants in the financial marketplace; these differences must be handled by business participants.

CHAPTER SUMMARY

Finance is the study of managing money. Because everyone must deal with money in one context or another, the study of finance is universally important. Finance can be distinguished from accounting by noting that the accounting function reports what has already happened, whereas finance involves making decisions that affect the future.

There are three main areas of study in finance. Markets and institutions deal with the financial intermediaries, who can be either suppliers or users of funds. The institutions that participate in the financial markets bring the suppliers and the users of funds together. The financial markets establish security prices so that all of the funds supplied are used and the markets clear. Investments is the study of how money is converted into more money over time. It includes how investment portfolios are created and how securities are selected. Corporate finance deals with financial problems and issues that face a firm. These include evaluating whether projects should be taken and how projects should be financed, and evaluating the financial health of the firm.

CHAPTER 1 An Overview of Finance

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The goal of the financial manager is to maximize shareholder wealth. Maximizing profits fails to consider the timing and riskiness of the firm and may be short-sighted. Wealth maximization requires the financial manager to maximize the price of the firm's stock. This requires taking a long-term view of cash flows because the stock price is determined by the current value of all future cash flows.

The following five assumptions touch on much that will be discussed later in the text:

1.Greater returns require taking greater risk.

2.Good deals disappear fast.

3.The value of money depends on when it is received.

4.Cash is king.

5.Not everyone knows the same things.

Chapter 2 begins our study of the financial markets and

institutions.

KEY WORDS

agency cost 10	diversification 4	financial markets 3	opportunity cost 15
asymmetric information 16	efficient markets 15	financial system 6	portfolio 4
capital markets 3	finance 3	investments 4	real rate of interest 12
corporate finance 5	financial institutions 3	money markets 3	risk-return tradeoff 4

DISCUSSION OUESTIONS

1.Why is profit maximization not an appropriate goal for firm managers?

2.Wealth maximization is the goal of financial managers. What, specifically, can the financial manager do to improve shareholder wealth? Discuss this issue in terms of the firm attributes that actually influence shareholder wealth.

3.Discuss the following in terms of agency costs.

a.Why are financial managers not as concerned about bondholder wealth as they are about stockholder wealth?

b.What do bondholders do to protect themselves?

c.Why should financial managers be concerned with keeping bondholders satisfied?

4.Discuss the following in terms of the risk-return tradeoff.

a.Distinguish between actual returns and expected returns.

b.Distinguish between expected returns and required returns.

c.Which must rise with increasing risk?

d.If the expected return is less than the required return, will the investor buy the security?

e.Will the actual return always be greater for higher-risk securities?

5.In an efficient market, if the required return is 10%, what is the expected return? Explain your answer.

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6.Why are financial managers so concerned with comput­ ing cash flows when accounting earnings and income data are more readily available?

7.An investor was reviewing a company with the intent of purchasing shares of stock. In the annual report the pres­ ident is quoted as saying that the firm's primary goal is to increase the value of shareholders' equity. However, after additional reading the investor learned of possibly con­ tradictory actions by the firm. Discuss each of the follow­ ing with respect to how the firm's stock price may react.

a.The company contributed $5 million to the local hospital development fund. The firm is the major employer in a small town and the hospital is in danger of closing.

b.The company is spending $500 million to open a new plant in Korea. The new plant will not be

PROBLEMS

1. Expected earnings per share of a company's stock is $5.00. The current price of the stock is $50.

a.What is the current expected return?

b.If the stock price rises to $60 because of increased demand, what will the expected return be?

сIf the stock price falls to $45 because a news release states that the firm is now more risky, what will the expected return be?

d.Which maxim discussed in this chapter best explains the change in return computed in part c?

operational for 5 years, so the firm's net income will fall during this period.

сThe firm is increasing its use of debt financing. The risk of the firm is not significantly increased by the additional debt.

d.The firm is embarking on a plan to upgrade its production process using new, untried technol­ ogy. If the new systems work, substantial savings could result. If the systems fail, orders will be delayed or unfilled and many customers can be expected to go elsewhere.

e.The firm will decrease its dividend payout ratio. The firm proposes no new investment opportu­ nities.

2.Expected earnings per share of a firm's stock are $1.50. This stock is selling for $35.

a.What is the current expected return?

b.If the stock price increases to $40, what will the expected return be?

сIf the stock price falls to $30, what will the expected return be?