Some Alternative Investment Rules

WHY USE NET PRESENT VALUE?

Before examining competitors of the NPV approach, we should ask: Why consider usingNPV in the first place? Answering this question will put the rest of this chapter in a properperspective. There are actually a number of arguments justifying the use of NPV, and youmay have already seen the detailed one of Chapter 3. We now present one of the simplestjustifications through an example.

EXAMPLE

The Alpha Corporation is considering investing in a riskless project costing $100.The project pays $107 at date 1 and has no other cash flows. The managers of thefirm might contemplate one of two strategies:
1. Use $100 of corporate cash to invest in the project. The $107 will be paid as adividend in one period.
2. Forgo the project and pay the $100 of corporate cash as a dividend today.If strategy 2 is employed, the stockholder might deposit the dividend in the bankfor one period. Because the project is riskless and lasts for one period, the stock-holder would prefer strategy 1 if the bank interest rate was below 7 percent. Inother words, the stockholder would prefer strategy 1 if strategy 2 produced lessthan $107 by the end of the year.

The comparison can easily be handled by NPV analysis. If the interest rate is 6 percent,the NPV of the project is Because the NPV is positive, the project should be accepted. Of course, a bank interest rateabove 7 percent would cause the project’s NPV to be negative, implying that the projectshould be rejected.

Thus, our basic point is:
Accepting positive NPV projects benefits the stockholders.

Although we used the simplest possible example, the results could easily be applied tomore plausible situations. If the project lasted for many periods, we would calculate theNPV of the project by discounting all the cash flows. If the project were risky, we could de-termine the expected return on a stock whose risk is comparable to that of the project. Thisexpected return would serve as the discount rate.

Having shown that NPV is a sensible approach, how can we tell whether alternative ap-proaches are as good as NPV? The key to NPV is its three attributes:

1. NPV Uses Cash Flows Cash flows from a project can be used for other corporate pur-poses (e.g., dividend payments, other capital-budgeting projects, or payments of corporateinterest). By contrast, earnings are an artificial construct. While earnings are useful to ac-countants, they should not be used in capital budgeting because they do not represent cash.
2. NPV Uses All the Cash Flows of the Project Other approaches ignore cash flows be-yond a particular date; beware of these approaches.
3. NPV Discounts the Cash Flows Properly Other approaches may ignore the time valueof money when handling cash flows. Beware of these approaches as well.

THE PAYBACK PERIOD RULE

Defining the Rule
One of the most popular alternatives to NPV is the payback period rule. Here is how thepayback period rule works.

Consider a project with an initial investment of $50,000. Cash flows are $30,000,$20,000, and $10,000 in the first three years, respectively. These flows are illustrated inFigure 6.1. A useful way of writing down investments like the preceding is with the notation:
(-$50,000, $30,000, $20,000, $10,000)

The minus sign in front of the $50,000 reminds us that this is a cash outflow for the investor,and the commas between the different numbers indicate that they are received—or if theyare cash outflows, that they are paid out—at different times. In this example we are assum-ing that the cash flows occur one year apart, with the first one occurring the moment we de-cide to take on the investment.

The firm receives cash flows of $30,000 and $20,000 in the first two years, which addup to the $50,000 original investment. This means that the firm has recovered its investmenwithin two years. In this case two years is the payback period of the investment.

The payback period rule for making investment decisions is simple. A particular cut-off time, say two years, is selected. All investment projects that have payback periods oftwo years or less are accepted and all of those that pay off in more than two years—if atall—are rejected.

Problems with the Payback Method

There are at least three problems with the payback method. To illustrate the first two prob-lems, we consider the three projects in Table 6.1. All three projects have the same three-year payback period, so they should all be equally attractive—right?

Actually, they are not equally attractive, as can be seen by a comparison of differentpairs of projects.

Problem 1: Timing of Cash Flows within the Payback Period Let us compare projectA with project B. In years 1 through 3, the cash flows of project A rise from $20 to $50 whilethe cash flows of project B fall from $50 to $20. Because the large cash flow of $50 comesearlier with project B, its net present value must be higher. Nevertheless, we saw above thatthe payback periods of the two projects are identical. Thus, a problem with the payback pe-riod is that it does not consider the timing of the cash flows within the payback period. Thisshows that the payback method is inferior to NPV because, as we pointed out earlier, theNPV approach discounts the cash flows properly.

Problem 2: Payments after the Payback Period Now consider projects B and C, whichhave identical cash flows within the payback period. However, project C is clearly preferredbecause it has the cash flow of $60,000 in the fourth year. Thus, another problem with thepayback method is that it ignores all cash flows occurring after the payback period. Thisflaw is not present with the NPV approach because, as we pointed out earlier, the NPV ap-proach uses all the cash flows of the project. The payback method forces managers to havean artificially short-term orientation, which may lead to decisions not in the shareholders’best interests.

Problem 3: Arbitrary Standard for Payback Period We do not need to refer to Table6.1 when considering a third problem with the payback approach. When a firm uses theNPV approach, it can go to the capital market to get the discount rate. There is no compa-rable guide for choosing the payback period, so the choice is arbitrary to some extent.

Managerial Perspective
The payback rule is often used by large and sophisticated companies when making rela-tively small decisions. The decision to build a small warehouse, for example, or to pay fora tune-up for a truck is the sort of decision that is often made by lower-level management.Typically a manager might reason that a tune-up would cost, say, $200, and if it saved $120each year in reduced fuel costs, it would pay for itself in less than two years. On such a ba-sis the decision would be made.

Although the treasurer of the company might not have made the decision in the sameway, the company endorses such decision making. Why would upper management condoneor even encourage such retrograde activity in its employees? One answer would be that itis easy to make decisions using the payback rule. Multiply the tune-up decision into 50 suchdecisions a month, and the appeal of this simple rule becomes clearer.

Perhaps most important though, the payback rule also has some desirable features formanagerial control. Just as important as the investment decision itself is the company’s abil-ity to evaluate the manager’s decision-making ability. Under the NPV rule, a long time maypass before one decides whether or not a decision was correct. With the payback rule weknow in two years whether the manager’s assessment of the cash flows was correct.

It has also been suggested that firms with very good investment opportunities but no avail-able cash may justifiably use the payback method. For example, the payback method could beused by small, privately held firms with good growth prospects but limited access to the capi-tal markets. Quick cash recovery may enhance the reinvestment possibilities for such firms.

Notwithstanding all of the preceding rationale, it is not surprising to discover that asthe decision grows in importance, which is to say when firms look at bigger projects, theNPV becomes the order of the day. When questions of controlling and evaluating the man-ager become less important than making the right investment decision, the payback periodis used less frequently. For the big-ticket decisions, such as whether or not to buy a machine,build a factory, or acquire a company, the payback rule is seldom used.

Summary of the Payback Period Rule

To summarize, the payback period is not the same as the NPV rule and is therefore con-ceptually wrong. With its arbitrary cutoff date and its blindness to cash flows after that date,it can lead to some flagrantly foolish decisions if it is used too literally. Nevertheless, be-cause it is so simple, companies often use it as a screen for making the myriad of minor in-vestment decisions they continually face.

Although this means that you should be wary of trying to change rules like the paybackperiod when you encounter them in companies, you should probably be careful not to fall intothe sloppy financial thinking they represent. After this course you would do your company adisservice if you ever used the payback period instead of the NPV when you had a choice.

THE DISCOUNTED PAYBACK PERIOD RULE

Aware of the pitfalls of the payback approach, some decision makers use a variant called thediscounted payback period rule.Under this approach,we first discount the cash flows. Thenwe ask how long it takes for the discounted cash flows to equal the initial investment.

For example, suppose that the discount rate is 10 percent and the cash flows on a proj-ect are given by
(-$100, $50, $50, $20)

This investment has a payback period of two years, because the investment is paid back inthat time.
To compute the project’s discounted payback period, we first discount each of the casflows at the 10-percent rate. In discounted terms, then, the cash flows look like
[-$100, $50/1.1, $50/(1.1)]=(-$100, $45.45, $41.32, $15.03)

The discounted payback period of the original investment is simply the payback period forthese discounted cash flows. The payback period for the discounted cash flows is slightly lessthan three years since the discounted cash flows over the three years are $101.80 ($45.45 $41.32  $15.03). As long as the cash flows are positive, the discounted payback period willnever be smaller than the payback period, because discounting will lower the cash flows.

At first glance the discounted payback may seem like an attractive alternative, but oncloser inspection we see that it has some of the same major flaws as the payback. Like pay-back, discounted payback first requires us to make a somewhat magical choice of an arbi-trary cutoff period, and then it ignores all of the cash flows after that date.

If we have already gone to the trouble of discounting the cash flows, any small appealto simplicity or to managerial control that payback may have, has been lost. We might justas well add up the discounted cash flows and use the NPV to make the decision. Althoughdiscounted payback looks a bit like the NPV, it is just a poor compromise between the pay-back method and the NPV.

How to Value Bonds and Stocks

How bonds are valued，Since the future cashflows of bonds are known, application of net-present-value techniques is fairly straightfor-ward. The uncertainty of future cash flows makes the pricing of stocks according to NPVmore difficult.

DEFINITION AND EXAMPLE OF A BOND

A bond is a certificate showing that a borrower owes a specified sum. In order to repay themoney, the borrower has agreed to make interest and principal payments on designateddates. For example, imagine that Kreuger Enterprises just issued 100,000 bonds for $1,000each, where the bonds have a coupon rate of 5 percent and a maturity of two years. Intereston the bonds is to be paid yearly. This means that:
1. $100 million (100,000  $1,000) has been borrowed by the firm
.2. The firm must pay interest of $5 million (5%  $100 million) at the end of one year
.3. The firm must pay both $5 million of interest and $100 million of principal at the end oftwo years.

We now consider how to value a few different types of bonds.

HOW TO VALUE BONDS

Pure Discount Bonds
The pure discount bond is perhaps the simplest kind of bond. It promises a single payment,say $1, at a fixed future date. If the payment is one year from now, it is called a one-year dis-count bond; if it is two years from now, it is called a two-year discount bond, and so on. Thedate when the issuer of the bond makes the last payment is called the maturity date of thebond, or just its maturity for short. The bond is said to mature or expire on the date of its fi-nal payment. The payment at maturity ($1 in this example) is termed the bond’s face value.
Pure discount bonds are often called zero-coupon bonds or zeros to emphasize the factthat the holder receives no cash payments until maturity. We will use the terms zero, bullet,and discount interchangeably to refer to bonds that pay no coupons.

The first row of Figure 5.1 shows the pattern of cash flows from a four-year pure dis-count bond. Note that the face value, F, is paid when the bond expires in the 48th month.There are no payments of either interest or principal prior to this date.

In the previous chapter, we indicated that one discounts a future cash flow to determineits present value. The present value of a pure discount bond can easily be determined by thetechniques of the previous chapter. For short, we sometimes speak of the value of a bondinstead of its present value.

Consider a pure discount bond that pays a face value of F in T years, where the interestrate is r in each of the T years. (We also refer to this rate as the market interest rate.) Becausethe face value is the only cash flow that the bond pays, the present value of this face amount is

The present value formula can produce some surprising results. Suppose that the in-terest rate is 10 percent. Consider a bond with a face value of $1 million that matures in 20years. Applying the formula to this bond, its PV is given by

Level-Coupon Bonds
Many bonds, however, are not of the simple, pure discount variety. Typical bonds issued byeither governments or corporations offer cash payments not just at maturity, but also at reg-ular times in between. For example, payments on U.S. government issues and Americancorporate bonds are made every six months until the bond matures. These payments arecalled the coupons of the bond. The middle row of Figure 5.1 illustrates the case of a four-year, level-coupon bond: The coupon, C, is paid every six months and is the same through-out the life of the bond.

Note that the face value of the bond, F, is paid at maturity (end of year 4). F is some-times called the principal or the denomination. Bonds issued in the United States typicallyhave face values of $1,000, though this can vary with the type of bond.

Financial Markets and Net Present Value: First Principles of Finance (Advanced)

Finance refers to the process by which special markets deal with cash flows over time.These markets are called financial markets. Making investment and financing deci-sions requires an understanding of the basic economic principles of financial markets.This introductory chapter describes a financial market as one that makes it possible for indi-viduals and corporations to borrow and lend. As a consequence, financial markets can beused by individuals to adjust their patterns of consumption over time and by corporations toadjust their patterns of investment spending over time. The main point of this chapter is thatindividuals and corporations can use the financial markets to help them make investment de-cisions. We introduce one of the most important ideas in finance: net present value.

THE FINANCIAL MARKET ECONOMY

Financial markets develop to facilitate borrowing and lending between individuals. Here wetalk about how this happens. Suppose we describe the economic circumstances of two peo-ple, Tom and Leslie. Both Tom and Leslie have current income of $100,000. Tom is a verypatient person, and some people call him a miser. He wants to consume only $50,000 ofcurrent income and save the rest. Leslie is a very impatient person, and some people callher extravagant. She wants to consume $150,000 this year. Tom and Leslie have differentintertemporal consumption preferences.

Such preferences are personal matters and have more to do with psychology than withfinance. However, it seems that Tom and Leslie could strike a deal: Tom could give up someof his income this year in exchange for future income that Leslie can promise to give him.Tom can lend $50,000 to Leslie, and Leslie can borrow $50,000 from Tom.

Suppose that they do strike this deal, with Tom giving up $50,000 this year in exchangefor $55,000 next year. This is illustrated in Figure 3.1 with the basic cash flow time chart,a representation of the timing and amount of the cash flows. The cash flows that are receivedare represented by an arrow pointing up from the point on the time line at which the cashflow occurs. The cash flows paid out are represented by an arrow pointing down. In otherwords, for each dollar Tom trades away or lends, he gets a commitment to get it back aswell as to receive 10 percent more.

In the language of finance, 10 percent is the annual rate of interest on the loan. Whena dollar is lent out, the repayment of $1.10 can be thought of as being made up of two parts.First, the lender gets the dollar back; that is the principal repayment. Second, the lender re-ceives an interest payment, which is $0.10 in this example.

Now, not only have Tom and Leslie struck a deal, but as a by-product of their bargainthey have created a financial instrument, the IOU. This piece of paper entitles whoever re-ceives it to present it to Leslie in the next year and redeem it for $55,000. Financial instru-ments that entitle whoever possesses them to receive payment are called bearer instrumentsbecause whoever bears them can use them. Presumably there could be more such IOUs inthe economy written by many different lenders and borrowers like Tom and Leslie.

The Anonymous Market

If the borrower does not care whom he has to pay back, and if the lender does not carewhose IOUs he is holding, we could just as well drop Tom’s and Leslie’s names from theircontract. All we need is a record book, in which we could record the fact that Tom has lent$50,000 and Leslie has borrowed $50,000 and that the terms of the loan, the interest rate,are 10 percent. Perhaps another person could keep the records for borrowers and lenders,for a fee, of course. In fact, and this is one of the virtues of such an arrangement, Tom andLeslie wouldn’t even need to meet. Instead of needing to find and trade with each other, theycould each trade with the record keeper. The record keeper could deal with thousands ofsuch borrowers and lenders, none of whom would need to meet the other.

Institutions that perform this sort of market function, matching borrowers and lendersor traders, are called financial intermediaries. Stockbrokers and banks are examples of fi-nancial intermediaries in our modern world. A bank’s depositors lend the bank money, andthe bank makes loans from the funds it has on deposit. In essence, the bank is an interme-diary between the depositors and the ultimate borrowers. To make the market work, wemust be certain that the market clears. By market clearing we mean that the total amountthat people like Tom wish to lend to the market should equal the total amount that peoplelike Leslie wish to borrow.

Market Clearing

If the lenders wish to lend more than the borrowers want to borrow, then presumably the in-terest rate is too high. Because there would not be enough borrowing for all of the lendersat, say, 15 percent, there are really only two ways that the market could be made to clear. Oneis to ration the lenders. For example, if the lenders wish to lend $20 million when interest rates are at 15 percent and the borrowers wish to borrow only $8 million, the market couldtake, say, 8/20 of each dollar, or $0.40, from each of the lenders and distribute it to the bor-rowers. This is one possible scheme for making the market clear, but it is not one that wouldbe sustainable in a free and competitive marketplace. Why not?

To answer this important question, let’s go back to our lender, Tom. Tom sees that in-terest rates are 15 percent and, not surprisingly, rather than simply lending the $50,000 thathe was willing to lend when rates were 10 percent, Tom decides that at the higher rates hewould like to lend more, say $80,000. But since the lenders want to lend more money thanthe borrowers want to borrow, the record keepers tell Tom that they won’t be able to takeall of his $80,000; rather, they will take only 40 percent of it, or $32,000. With the interestrate at 15 percent, people are not willing to borrow enough to match up with all of the loansthat are available at that rate.

Tom is not very pleased with that state of affairs, but he can do something to improvehis situation. Suppose that he knows that Leslie is borrowing $20,000 in the market at the 15percent interest rate. That means that Leslie must repay $20,000 on her loan next year plusthe interest of 15 percent of $20,000 or 0.15  $20,000
$3,000. Suppose that Tom goesto Leslie and offers to lend her the $20,000 for 14 percent. Leslie is happy because she willsave 1 percent on the deal and will need to pay back only $2,800 in interest next year. Thisis $200 less than if she had borrowed from the record keepers. Tom is happy too, because hehas found a way to lend some of the money that the record keepers would not take. The netresult of this transaction is that the record keepers have lost Leslie as a customer. Why shouldshe borrow from them when Tom will lend her the money at a lower interest rate?

Tom and Leslie are not the only ones cutting side deals in the marketplace, and it isclear that the record keepers will not be able to maintain the 15 percent rate. The interestrate must fall if they are to stay in business.
Suppose, then, that the market clears at the rate of 10 percent. At this rate the amountof money that the lenders wish to lend is exactly equal to the amount that the borrowers de-sire. We refer to the interest rate that clears the market, 10 percent in our example, as theequilibrium rate of interest.

In this section we have shown that in the market for loans, bonds or IOUs are traded.These are financial instruments. The interest rate on these loans is set so that the total de-mand for such loans by borrowers equals the total supply of loans by lenders. At a higherinterest rate, lenders wish to supply more loans than are demanded, and if the interest rateis lower than this equilibrium level, borrowers demand more loans than lenders are willingto supply.

THE COMPETITIVE MARKET

In the previous analysis we assumed the individual moves freely along the line AB, and weignored—and assumed that the individual ignored—any effect his borrowing or lending de-cisions might have on the equilibrium interest rate itself. What would happen, though, if thetotal amount of loans outstanding in the market when the person was doing no borrowingor lending was $10 million, and if our person then decided to lend, say, $5 million? Hislending would be half as much as the rest of the market put together, and it would not beunreasonable to think that the equilibrium interest rate would fall to induce more borrow-ers into the market to take his additional loans. In such a situation the person would havesome power in the market to influence the equilibrium rate significantly, and he would takethis power into consideration in making his decisions.

In the modern financial market, however, the total amount of borrowing and lending isnot $10 million; rather, as we saw in Chapter 1, it is closer to $10 trillion. In such a hugemarket no one investor or even any single company can have a significant effect (althougha government might). We assume, then, in all of our subsequent discussions and analysesthat the financial market is competitive. By that we mean no individuals or firms think theyhave any effect whatsoever on the interest rates that they face no matter how much bor-rowing, lending, or investing they do. In the language of economics, individuals who re-spond to rates and prices by acting as though they have no influence on them are called pricetakers, and this assumption is sometimes called the price-taking assumption. It is the con-dition of perfectly competitive financial markets (or, more simply, perfect markets). Thefollowing conditions are likely to lead to this:
1. Trading is costless. Access to the financial markets is free.
2. Information about borrowing and lending opportunities is available.
3. There are many traders, and no single trader can have a significant impact on market prices.

How Many Interest Rates Are There in a Competitive Market?

An important point about this one-year market where no defaults can take place is that onlyone interest rate can be quoted in the market at any one time. Suppose that some competingrecord keepers decide to set up a rival market. To attract customers, their business plan is tooffer lower interest rates, say, 9 percent. Their business plan is based on the hope that theywill be able to attract borrowers away from the first market and soon have all of the business.

Their business plan will work, but it will do so beyond their wildest expectations. Theywill indeed attract the borrowers, all $11 million worth of them! But the matter doesn’t stopthere. By offering to borrow and lend at 9 percent when another market is offering 10 per-cent, they have created the proverbial money machine.

The world of finance is populated by sharp-eyed inhabitants who would not let this op-portunity slip by them. Any one of these, whether a borrower or a lender, would go to thenew market and borrow everything he could at the 9-percent rate. At the same time he wasborrowing in the new market, he would also be striking a deal to lend in the old market atthe 10-percent rate. If he could borrow $100 million at 9 percent and lend it at 10 percent,he would be able to net 1 percent, or $1 million, next year. He would repay the $109 mil-lion he owed to the new market from the $110 million he receives when the 10-percent loanshe made in the original market are repaid, pocketing $1 million profit.

This process of striking a deal in one market and an offsetting deal in another marketsimultaneously and at more favorable terms is called arbitrage, and doing it is called arbi-traging. Of course, someone must be paying for all this free money, and it must be the recordkeepers because the borrowers and the lenders are all making money. Our intrepid entre-preneurs will lose their proverbial shirts and go out of business. The moral of this is clear:As soon as different interest rates are offered for essentially the same risk-free loans, arbi-trageurs will take advantage of the situation by borrowing at the low rate and lending at thehigh rate. The gap between the two rates will be closed quickly, and for all practical pur-poses there will be only one rate available in the market.

THE BASIC PRINCIPLE

We have already shown how people use the financial markets to adjust their patterns of con-sumption over time to fit their particular preferences. By borrowing and lending, they cangreatly expand their range of choices. They need only to have access to a market with aninterest rate at which they can borrow and lend.

In the previous section we saw how these savings and consumption decisions dependon the interest rate. The financial markets also provide a benchmark against which proposedinvestments can be compared, and the interest rate is the basis for a test that any proposedinvestment must pass. The financial markets give the individual, the corporation, or eventhe government a standard of comparison for economic decisions. This benchmark is criti-cal when investment decisions are being made.

The way we use the financial markets to aid us in making investment decisions is a di-rect consequence of our basic assumption that individuals can never be made worse off byincreasing the range of choices open to them. People always can make use of the financialmarkets to adjust their savings and consumption by borrowing or lending. An investmentproject is worth undertaking only if it increases the range of choices in the financial mar-kets. To do this the project must be at least as desirable as what is available in the financialmarkets.

2、If it were not as desirable as what the financial markets have to offer, people couldsimply use the financial markets instead of undertaking the investment. This point will gov-ern us in all our investment decisions. It is the first principle of investment decision making,and it is the foundation on which all of our rules are built.

Accounting Statements and Cash Flow

The basic accounting statements used for reporting corporate ac-tivity. The focus of the chapter is the practical details of cash flow. It will becomeobvious to you in the next several chapters that knowing how to determine cash flowhelps the financial manager make better decisions. Students who have had accountingcourses will not find the material new and can think of it as a review with an emphasis onfinance.

THE BALANCE SHEET

The balance sheet is an accountant’s snapshot of the firm’s accounting value on a particu-lar date, as though the firm stood momentarily still. The balance sheet has two sides: on theleft are the assets and on the right are the liabilities and stockholders’ equity. The balancesheet states what the firm owns and how it is financed. The accounting definition that un-derlies the balance sheet and describes the balance is
Assets = Liabilities + Stockholders’ equity

We have put a three-line equality in the balance equation to indicate that it must alwayshold, by definition. In fact, the stockholders’ equity is defined to be the difference betweenthe assets and the liabilities of the firm. In principle, equity is what the stockholders wouldhave remaining after the firm discharged its obligations。

Table 2.1 gives the 20X2 and 20X1 balance sheet for the fictitious U.S. CompositeCorporation. The assets in the balance sheet are listed in order by the length of time it nor-mally would take an ongoing firm to convert them to cash. The asset side depends on thenature of the business and how management chooses to conduct it. Management must makedecisions about cash versus marketable securities, credit versus cash sales, whether to makeor buy commodities, whether to lease or purchase items, the types of business in which toengage, and so on. The liabilities and the stockholders’ equity are listed in the order inwhich they must be paid.

The liabilities and stockholders’ equity side reflects the types and proportions of fi-nancing, which depend on management’s choice of capital structure, as between debt andequity and between current debt and long-term debt.

When analyzing a balance sheet, the financial manager should be aware of three con-cerns: accounting liquidity, debt versus equity, and value versus cost.

Accounting Liquidity

Accounting liquidity refers to the ease and quickness with which assets can be convertedto cash. Current assets are the most liquid and include cash and those assets that will beturned into cash within a year from the date of the balance sheet. Accounts receivable are amounts not yet collected from customers for goods or services sold to them (after ad-justment for potential bad debts). Inventory is composed of raw materials to be used in pro-duction, work in process, and finished goods. Fixed assets are the least liquid kind of as-sets. Tangible fixed assets include property, plant, and equipment. These assets do notconvert to cash from normal business activity, and they are not usually used to pay ex-penses, such as payroll.

Some fixed assets are not tangible. Intangible assets have no physical existence but canbe very valuable. Examples of intangible assets are the value of a trademark or the value ofa patent. The more liquid a firm’s assets, the less likely the firm is to experience problemsmeeting short-term obligations. Thus, the probability that a firm will avoid financial dis-tress can be linked to the firm’s liquidity. Unfortunately, liquid assets frequently have lowerrates of return than fixed assets; for example, cash generates no investment income. To theextent a firm invests in liquid assets, it sacrifices an opportunity to invest in more profitableinvestment vehicles.

Debt versus Equity

Liabilities are obligations of the firm that require a payout of cash within a stipulated timeperiod. Many liabilities involve contractual obligations to repay a stated amount and inter-est over a period. Thus, liabilities are debts and are frequently associated with nominallyfixed cash burdens, called debt service, that put the firm in default of a contract if they arenot paid. Stockholders’ equity is a claim against the firm’s assets that is residual and notfixed. In general terms, when the firm borrows, it gives the bondholders first claim on thefirm’s cash flow.1Bondholders can sue the firm if the firm defaults on its bond contracts.This may lead the firm to declare itself bankrupt. Stockholders’ equity is the residual dif-ference between assets and liabilities:
Assets = Liabilities+Stockholders’ equity

This is the stockholders’ share in the firm stated in accounting terms. The accounting valueof stockholders’ equity increases when retained earnings are added. This occurs when thefirm retains part of its earnings instead of paying them out as dividends.

Value versus Cost

The accounting value of a firm’s assets is frequently referred to as the carrying value or thebook value of the assets.2Under generally accepted accounting principles (GAAP), au-dited financial statements of firms in the United States carry the assets at cost.3Thus theterms carrying value and book value are unfortunate. They specifically say “value,” whenin fact the accounting numbers are based on cost. This misleads many readers of financiastatements to think that the firm’s assets are recorded at true market values. Market value isthe price at which willing buyers and sellers trade the assets. It would be only a coincidenceif accounting value and market value were the same. In fact, management’s job is to createa value for the firm that is higher than its cost.

Many people use the balance sheet although the information each may wish to ex-tract is not the same. A banker may look at a balance sheet for evidence of accountingliquidity and working capital. A supplier may also note the size of accounts payable andtherefore the general promptness of payments. Many users of financial statements, in-cluding managers and investors, want to know the value of the firm, not its cost. This isnot found on the balance sheet. In fact, many of the true resources of the firm do not ap-pear on the balance sheet: good management, proprietary assets, favorable economic con-ditions, and so on.

• What is the balance-sheet equation?
• What three things should be kept in mind when looking at a balance sheet?

1、Bondholders are investors in the firm’s debt. They are creditors of the firm. In this discussion, the termbondholder means the same thing as creditor.
2、Confusion often arises because many financial accounting terms have the same meaning. This presents aproblem with jargon for the reader of financial statements. For example, the following terms usually refer to thesame thing: assets minus liabilities, net worth, stockholders’ equity, owner’s equity, and equity capitalization.
3、Formally, GAAP requires assets to be carried at the lower of cost or market value. In most instances cost islower than market value.

THE INCOME STATEMENT

The income statement measures performance over a specific period of time, say, a year.The accounting definition of income is
Revenue-Expenses=Income

If the balance sheet is like a snapshot, the income statement is like a video recording of whatthe people did between two snapshots. Table 2.2 gives the income statement for the U.S.Composite Corporation for 20X2.
The income statement usually includes several sections. The operations section reportsthe firm’s revenues and expenses from principal operations. One number of particular im-portance is earnings before interest and taxes (EBIT), which summarizes earnings beforetaxes and financing costs. Among other things, the nonoperating section of the incomestatement includes all financing costs, such as interest expense. Usually a second section reports as a separate item the amount of taxes levied on income. The last item on the in-come statement is the bottom line, or net income. Net income is frequently expressed pershare of common stock, that is, earnings per share.
When analyzing an income statement, the financial manager should keep in mindGAAP, noncash items, time, and costs.

Generally Accepted Accounting Principles

Revenue is recognized on an income statement when the earnings process is virtually com-pleted and an exchange of goods or services has occurred. Therefore, the unrealized appre-ciation in owning property will not be recognized as income. This provides a device forsmoothing income by selling appreciated property at convenient times. For example, if thefirm owns a tree farm that has doubled in value, then, in a year when its earnings from otherbusinesses are down, it can raise overall earnings by selling some trees. The matching prin-ciple of GAAP dictates that revenues be matched with expenses. Thus, income is reportedwhen it is earned, or accrued, even though no cash flow has necessarily occurred (for ex-ample, when goods are sold for credit, sales and profits are reported).

Noncash Items

The economic value of assets is intimately connected to their future incremental cash flows.However, cash flow does not appear on an income statement. There are several noncashitems that are expenses against revenues, but that do not affect cash flow. The most impor-tant of these is depreciation. Depreciation reflects the accountant’s estimate of the cost ofequipment used up in the production process. For example, suppose an asset with a five-year life and no resale value is purchased for $1,000. According to accountants, the $1,000cost must be expensed over the useful life of the asset. If straight-line depreciation is used,there will be five equal installments and $200 of depreciation expense will be incurred eachyear. From a finance perspective, the cost of the asset is the actual negative cash flow in-curred when the asset is acquired (that is, $1,000, not the accountant’s smoothed $200-per-year depreciation expense).

Another noncash expense is deferred taxes. Deferred taxes result from differences be-tween accounting income and true taxable income.4Notice that the accounting tax shownon the income statement for the U.S. Composite Corporation is $84 million. It can be bro-ken down as current taxes and deferred taxes. The current tax portion is actually sent to thetax authorities (for example, the Internal Revenue Service). The deferred tax portion is not.However, the theory is that if taxable income is less than accounting income in the currentyear, it will be more than accounting income later on. Consequently, the taxes that are notpaid today will have to be paid in the future, and they represent a liability of the firm. Thisshows up on the balance sheet as deferred tax liability. From the cash flow perspective,though, deferred tax is not a cash outflow.

Time and Costs

It is often useful to think of all of future time as having two distinct parts, the short run andthe long run. The short run is that period of time in which certain equipment, resources, andcommitments of the firm are fixed; but the time is long enough for the firm to vary its out-put by using more labor and raw materials. The short run is not a precise period of time thatwill be the same for all industries. However, all firms making decisions in the short run have some fixed costs, that is, costs that will not change because of fixed commitments. In realbusiness activity, examples of fixed costs are bond interest, overhead, and property taxes.Costs that are not fixed are variable. Variable costs change as the output of the firm changes;some examples are raw materials and wages for laborers on the production line.

In the long run, all costs are variable.5Financial accountants do not distinguish be-tween variable costs and fixed costs. Instead, accounting costs usually fit into a classifica-tion that distinguishes product costs from period costs. Product costs are the total produc-tion costs incurred during a period—raw materials, direct labor, and manufacturingoverhead—and are reported on the income statement as cost of goods sold. Both variableand fixed costs are included in product costs. Period costs are costs that are allocated to atime period; they are called selling, general, and administrative expenses. One period costwould be the company president’s salary.

NET WORKING CAPITAL

Net working capital is current assets minus current liabilities. Net working capital is posi-tive when current assets are greater than current liabilities. This means the cash that will be-come available over the next 12 months will be greater than the cash that must be paid out.The net working capital of the U.S. Composite Corporation is $275 million in 20X2 and$252 million in 20X1:

Current assets Current liabilities Net working capital
($ millions) - ($ millions) = ($ millions)
20X2 $761 - $486 = $275
20X1 707 - 455 = 252

In addition to investing in fixed assets (i.e., capital spending), a firm can invest in net work-ing capital. This is called the change in net working capital. The change in net workingcapital in 20X2 is the difference between the net working capital in 20X2 and 20X1; thatis, $275 million  $252 million
$23 million. The change in net working capital is usu-ally positive in a growing firm.

FINANCIAL CASH FLOW

Perhaps the most important item that can be extracted from financial statements is the ac-tual cash flow of the firm. There is an official accounting statement called the statement ofcash flows. This statement helps to explain the change in accounting cash and equivalents,which for U.S. Composite is $33 million in 20X2. (See Appendix 2B.) Notice in Table 2.1that Cash and equivalents increases from $107 million in 20X1 to $140 million in 20X2.However, we will look at cash flow from a different perspective, the perspective of finance.In finance the value of the firm is its ability to generate financial cash flow. (We will talkmore about financial cash flow in Chapter 7.)

The first point we should mention is that cash flow is not the same as net working cap-ital. For example, increasing inventory requires using cash. Because both inventories andcash are current assets, this does not affect net working capital. In this case, an increase ina particular net working capital account, such as inventory, is associated with decreasingcash flow.

Just as we established that the value of a firm’s assets is always equal to the value ofthe liabilities and the value of the equity, the cash flows received from the firm’s assets (thatis, its operating activities), CF(A), must equal the cash flows to the firm’s creditors, CF(B),and equity investors, CF(S):
CF(A) = CF(B) + CF(S)
The first step in determining cash flows of the firm is to figure out the cash flow from op-erations.As can be seen in Table 2.3, operating cash flow is the cash flow generated by busi-ness activities, including sales of goods and services. Operating cash flow reflects tax pay-ments, but not financing, capital spending, or changes in net working capital.

The total outgoing cash flow of the firm can be separated into cash flow paid to credi-tors and cash flow paid to stockholders. The cash flow paid to creditors represents a re-grouping of the data in Table 2.3 and an explicit recording of interest expense. Creditors arepaid an amount generally referred to as debt service. Debt service is interest payments plusrepayments of principal (that is, retirement of debt).An important source of cash flow is from selling new debt. U.S. Composite’s long-termdebt increased by $13 million (the difference between $86 million in new debt and $73 mil-lion in retirement of old debt.6) Thus, an increase in long-term debt is the net effect of newborrowing and repayment of maturing obligations plus interest expense.

WHAT IS CORPORATE FINANCE?

Suppose you decide to start a firm to make tennis balls. To do this, you hire managers tobuy raw materials, and you assemble a workforce that will produce and sell finished tennisballs. In the language of finance, you make an investment in assets such as inventory, ma-chinery, land, and labor. The amount of cash you invest in assets must be matched by anequal amount of cash raised by financing. When you begin to sell tennis balls, your firmwill generate cash. This is the basis of value creation. The purpose of the firm is to createvalue for you, the owner. The firm must generate more cash flow than it uses. The value isreflected in the framework of the simple balance-sheet model of the firm.

The Balance-Sheet Model of the Firm
Suppose we take a financial snapshot of the firm and its activities at a single point in time.Figure 1.1 shows a graphic conceptualization of the balance sheet, and it will help intro-duce you to corporate finance.

The assets of the firm are on the left-hand side of the balance sheet. These assets canbe thought of as current and fixed. Fixed assets are those that will last a long time, such asbuildings. Some fixed assets are tangible, such as machinery and equipment. Other fixedassets are intangible, such as patents, trademarks, and the quality of management. The othercategory of assets, current assets, comprises those that have short lives, such as inventory.The tennis balls that your firm has made but has not yet sold are part of its inventory. Unlessyou have overproduced, they will leave the firm shortly.
Before a company can invest in an asset, it must obtain financing, which means that itmust raise the money to pay for the investment. The forms of financing are represented onthe right-hand side of the balance sheet. A firm will issue (sell) pieces of paper called debt。

Corporate Finance

EXECUTIVE SUMMARY

The Video Product Company designs and manufactures very popular software forvideo game consoles. The company was started in 1999, and soon thereafter its game“Gadfly” appeared on the cover of Billboardmagazine. Company sales in 2000 wereover $20 million. Video Product’s initial financing of $2 million came from Seed Ltd., aventure-capital firm, in exchange for a 15-percent equity stake in the company. Now the fi-nancial management of Video Product realizes that its initial financing was too small. In thelong run Video Product would like to expand its design activity to the education and busi-ness areas. It would also like to significantly enhance its website for future Internet sales.However, at present the company has a short-run cash flow problem and cannot even buy$200,000 of materials to fill its holiday orders.
Video Product’s experience illustrates the basic concerns of corporate finance:
1. What long-term investment strategy should a company take on?
2. How can cash be raised for the required investments?
3. How much short-term cash flow does a company need to pay its bills?

These are not the only questions of corporate finance. They are, however, among the mostimportant questions and, taken in order, they provide a rough outline of our book.

One way that companies raise cash to finance their investment activities is by sellingor“issuing” securities. The securities, sometimes called financial instruments or claims,may be roughly classified as equity or debt, loosely called stocks or bonds. The differencebetween equity and debt is a basic distinction in the modern theory of finance. All securi-ties of a firm are claims that depend on or are contingent on the value of the firm.1In Section1.2 we show how debt and equity securities depend on the firm’s value, and we describethem as different contingent claims.
In Section 1.3 we discuss different organizational forms and the pros and cons of thedecision to become a corporation.
In Section 1.4 we take a close look at the goals of the corporation and discuss why max-imizing shareholder wealth is likely to be the primary goal of the corporation. Throughoutthe rest of the book, we assume that the firm’s performance depends on the value it createsfor its shareholders. Shareholders are better off when the value of their shares is increasedby the firm’s decisions.
A company raises cash by issuing securities to the financial markets. The market valueof outstanding long-term corporate debt and equity securities traded in the U.S. financialmarkets is in excess of $25 trillion. In Section 1.5 we describe some of the basic features ofthe financial markets. Roughly speaking, there are two basic types of financial markets: themoney markets and the capital markets. The last section of the chapter provides an outlineof the rest of the book.

We tend to use the words firm, company, and business interchangeably. However, there is a difference betweena firm and a corporation.

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