Financial management principles and applications 10th edition by arthur and martin

Low

PE~RSON

PRICE

EDITION

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Education


BR tE,F~e.O,N TEN TS
Preface xvii
P.ART 1: THE SCOPE AND ENVIRONMENT
OF FINANCIAL MANAGEMENT
CHAPTER 1
An Introduction to Financial Management 3
CH~PTER 2
Und,brstanding Financial Statements, Taxes, and Cash Flows 31
I

--

CHAPTER 3
Evaluating a Firm's Financial Performance 71
CHAPTER 4
Financial Forecasting, Planning, and Budgeting 107
PART 2: VALUATION OF FINANCIAL ASSETS
CHAPTER 5

The Value of Money 137
CHAPTER 6
Risk and Rates of Return 181
CHAPTER 7
Valuation and Characteristics of Bonds 22 3
CHAPTER 8
Stock Valuation 255

PART 3: INVESTMENT IN LONG-TERM ASSETS
CHAPTER 9
Capital Budgeting Decision Criteria 289
CHAPTER 10
Cash Flows and Other Topics in Capital Budgeting 327
CHAPTER 11
Capital Budgeting and Risk Analysis 371
CHAPTER 12
Cost of Capital 405
CHAPTER 13
Managing for Shareholder Value 435
vii


viii

BRIEF CONTENTS

,
PART 4: CAPITAL STRUCTURE AND DIVIDEND POLICY
CHAPTER

14

Raising Capital in the Financial Markets 469
CHAPTER

15

Analysis and Impact of Leverage 505
CHAPTER

16

Planning the Firm's Financing Mix 551
CHAPTER

17

Dividend Policy and Internal Financing 605
PART 5: WORKING-CAPITAL MANAGEMENT AND
SPECIAL TOPICS IN FINANCE
CHAPTER

18

Working-Capital Management and Short-Term Financing 645
CHAPTER

19

Cash and Marketable Securities Management 673

CHAPTER

20

Accounts Receivable and Inventory Management 705
PART 6: SPECIAL TOPICS IN FINANCE
CHAPTER

21

Risk Management 739
CHAPTER

22

International Business Finance 773
CHAPTER

23

Corporate Restructuring: Combinations and Divestitures* 23-1
CHAPTER

24

Term Loans and Leases* 24-1
Appendixes A-I
Glossary G-l
Indexes I-I

*Chapters 23 and 24 can be found at www.prenhall.comlkeown


CONTENT:S
Preface

.PART

XVii

1: THE SCOPE AND ENVIRONMENT

-

­

OFFINANCIAL MANAGEMENT

-

CHAPTER

--

- --

1


An Introduction to Financial Management 3

What Is Finance? 4

Goal of the Firm 4

Legal Forms of Business Organization 7

Ten Principles That Form the Basics of Financial Management 12

PRINCIPLE 1: The Risk-Return Trade-Off-We won't take on additional risk unless

we expect to be compensated with additional return 13

PRINCIPLE 2: The Time Value of Money-A dollar received today is worth more

than a dollar received in the future 14

PRINCIPLE 3: Cash-Not Profits-Is King 14

PRINCIPLE 4: Incremental Cash Flows-It's only what changes that counts 15

PRINCIPLE 5: The Curse of Competitive Markets-Why it's hard to find

exceptionally profitable projects 15

PRINCIPLE 6: Efficient Capital Markets-The markets are quick and the prices are

right 16

PRINCIPLE 7: The Agency Problems-Managers won't work for owners unless it's

in their best interest 17

PRiNCIPLE 8: Taxes Bias Business Decisions 18

PRINCIPLE 9: All Risk Is Not Equal-Some risk can be diversified away, and some

cannot 18

PRINCIPLE 10: Ethical behavior is doing the right thing, and ethical dilemmas are

everywhere in finance 20

Overview of the Text 22

Finance and the Multinational Firm: The New Role 24

How Financial Managers Use This Material 25

Summary 25


-----

--/ CHAPTER

2


Understanding Financial Statements, Taxes, and Cash Flows 31

The Income Statement: Measuring a Company's Profits 32

The Balance Sheet: Measuring a Firm's Book Value 34

Computing a Company's Taxes 41

Measuring Free Cash Flows 44

Financial Statements and International Finance 49

How Financial Managers Use This Material 50

Summary 50

Appendix 2A: Measuring Cash Flows: An Accounting Perspective 66

ix


x

CONTENTS

JCHAPTER 3

Evaluating a Firm's Financial Performance

71

Financial Ratio Analysis 72

The DuPont Analysis: An Integrative Approach to Ratio Analysis 85

How Financial Managers Use This Material 89

Summary 89

CHAPTER 4

Financial Forecasting, Planning, and Budgeting

107


Financial Forecasting 108

Limitations of the Percent of Sales Forecast Method 113

The Sustainable Rate of Growth 115

Financial Planning and Budgeting 117

How Financial Managers Use This Material 120

Summary 120

PART 2: VALUATION OF FINANCIAL ASSETS

.,j CHAPTER 5

The Time Value of Money

137


Compound Interest and Future Value 138

Compound Interest with Nonannual Periods 146

Present Value 147
Annuities-A Level Stream 150

Annuities Due 157

Present Value of Complex Stream 160

Perpetuities and Infinite Annuities 163

Making Interest Rates Comparable 163

The Multinational Firm: The Time Value of Money 164

How Financial Managers Use This Material 165

Summary 165

\,/ CHAPTER 6

Risk and Rates of Return

181


Rates of Return in the Financial Markets 182

The Effects of Inflation on Rates of Return and the Fisher Effect 184

The Term Structure of Interest Rates 185

Expected Return 187

Risk 188

Risk and Diversification 192

Measuring Market Risk 196

Measuring a Portfolio's Beta 201

The Investor's Required Rate of Return 203

How Financial Managers Use This Material 207

Summary 208


\

CONTENTS

j

CHAPTER 7

Valuation and Characteristics of Bonds

223


Types of Bonds 224

Terminology and Characteristics of Bonds 22 7

Definitions of Value 231

Determinants of Value 232

Valuation: The Basic Process 234

Bond Valuation 235

The Bondholder's Expected Rate of Return (Yield to Maturity) 238

Bond Valuation: Five Important Relationships 240

How Financial Managers Use This Material 246

Summary 246

'/ CHAPTER 8

Stock Valuation

255


Features and Types of Preferred Stock 256

Valuing Preferred Stock 259

Characteristics of Common Stock 261

Valuing Common Stock 267

Stockholder's Expected Rate of Return 272

How Financial Managers Use This Material 275

Summary 275

Appendix 8A: The Relationship between Value and Earnings 283


PAR T 3: I' N VE S T MEN TIN LON G - T E R MAS SET S
CHAPTER 9

Capital-Budgeting Decision Criteria

289


Finding Profitable Projects 290

Payback Period 292

Net Present Value 295

Profitability Index (Benefit/Cost Ratio) 298

Internal Rate of Return 299

Ethics in Capital Budgeting 312

A Glance at Actual Capital-Budgeting Practices 313

How Financial Managers Use This Material 314

Summary 315

CHAPTER 10

Cash Flows and Other Topics in Capital Budgeting

327

Guidelines for Capital Budgeting 328

An Overview of the Calculations of a Project's Free Cash Flows 332

Complications in Capital Budgeting: Capital Rationing and Mutually Exclusive

Projects 344


I
~

xi


xii

CONTENTS

The Multinational Firm: International Complications in Calculating Expected Free

Cash Flows 353

How Financial Managers Use This Material 353

Summary 354

CHAPTER

11

Capital Budgeting and Risk Analysis

371


Risk and the Investment Decision 372

Methods for Incorporating Riskinto Capital Budgeting 376

Other Approaches to Evaluating Risk in Capital Budgeting 383

The Multinational Firm: Capital Budgeting and Risk 389

How Financial Managers Use This Material 390

Summary 390

CHAPTER

12


Cost of Capital

405


The Cost of Capital: Key Definitions and Concepts 406

Determining Individual Costs of Capital 407

The Weighted Average Cost of Capital 414

Cost of Capital in Practice: Briggs & Stratton 417

Calculating Divisional Costs of Capital: PepsiCo, Inc. 419

Using a Firm's Cost of Capital to Evaluate New Capital Investments 420

How Financial Managers Use This Material 424

Summary 424

CHAPTER

13


Managing for Shareholder Value

435


Who Are the Top Creators of Shareholder Value? 437

Business Valuation-The Key to Creating Shareholder Value 438

Value Drivers 443

Economic Value Added (EVA)® 445

Paying for Performance 448

How Financial Managers Use This Material 456

Summary 457


PART 4: CAPITAL STRUCTURE AND DIVIDEND POLICY
CHAPTER

14


Raising Capital in the Financial Markets

469


The Financial Manager, Internal and External Funds, and Flexibility 472

The Mix of Corporate Securities Sold in the Capital Market 474

Why Financial Markets Exist 475

Financing of Business: The Movement of Funds Through the Economy 478

Components of the U.S. Financial Market System 481

The Investment Banker 489

More on Private Placements: The Debt Side 493



CONTENTS

xiii

Flotation Costs 494

Regulation 495

The Multinational Firm: Efficient Financial Markets and Intercountry Risk 499

How Financial Managers Use This Material 500

?ummary 501


CHAPTER 15

Analysis and Impact of Leverage

505


Business and Financial Risk 506

Break-Even Analysis 509

Operating Leverage 519

Financial Leverage 524

Combination of Operating and Financial Leverage 527

The Multinational Firm: Business Risk and Global Sales 531

How Financial Managers Use This Material 532

Summary 533


CHAPTER 16

Planning the Firm's Financing Mix

551


Key Terms and Getting Started 552

A Glance at Capital Structure Theory 553

Basic Tools of Capital Structure Management 568

The Multinational Firm: Beware of Currency Risk 580

How Financial Managers Use This Material 581

Summary 587


CHAPTER 17

Dividend Policy and Internal Financing

605


Dividend Payment Versus Profit Retention 607

Does Dividend Policy Affect Stock Price? 608

The Dividend Decision in Practice 621

Dividend Payment Procedures 625

Stock Dividends and Stock Splits 625

Stock Repurchases 628

The Multinational Firm: The Case of Low Dividend Payments-So Where Do We

Invest? 631

How Financial Managers Use This Material 633

Summary 633


PART 5: WORKING-CAPITAL MANAGEMENT AND
S P E C I A L TOP I C SIN FIN A N C.E

CHAPTER 18

Working-Capital Management and Short-Term Financing

645


Managing Current Assets and Liabilities 646

Financing Working Capital with Current Liabilities 647


j


xiv

CONTENTS

Appropriate Level of Working Capital 648

Hedging Principles 648

Cash Conversion Cycle 651

Estimation of the Cost of Short-Term Credit 653

Sources of Short-Term Credit 654

Multinational Working-Capital Management 661

How Finance Managers Use This Material 662

Summary 662

CHAPTER 19

Cash and Marketable Securities Management

673


What are Liquid Assets? 674

Why a Company Holds Cash 674

Cash-Management Objectives and Decisions 676

Collection and Disbursement Procedures 678

Composition of Marketable Securities Portfolio 684

The Multinational Firm: The Use of Cash and Marketable Securities 691

How Financial Managers Use This Material 691

Summary 691

CHAPTER 20

Accounts Receivable and Inventory Management

705


Accounts Receivable Management 706

Inventory Management 716

TQM and Inventory-Purchasing Management: The New Supplier

Relationships 724

How Financial Managers Use This Material 727

Summary 728

".

'./ CHAPTER 21

Risk Management

739


Futures 740

Options 746

Currency Swaps 757

The Multinational Firm and Risk Management 758

How Financial Managers Use This Material 759

Summary 759

CHAPTER 22

International Business Finance

773


The Globalization of Product and Financial Markets 774

Exchange Rates 775

Interest-Rate Parity Theory 785

Purchasing-Power Parity 785

Exposure to Exchange Rate Risk 787

Multinational Working-Capital Management 791



CONTENTS

International Financing and Capital-Structure Decisions 793
Direct Foreign Investment 794
How Financial Managers Use This Material 796
Swnmary 796
.1'~ CHAPTER 23
Corporate Restructuring: Combinations and Divestitures

~

Why Mergers Might Create Wealth 23-3
Determination of a Firm's Value 23-6
Divestitures 23-14
How Financial Managers Use This Material 23-17
Summary 23-19

~ CHAPTER 24
- , Term Loans and Leases

24-1

Term Loans 24-3
Loan Payment Calculation 24-5

Leases 24-7
The Economics of Leasing Versus Purchasing 24-16
How Financial Managers Use This Material 24-20
Summary 24-20
Appendixes A-I
Glossary G-l
Indexes I-I

*Chapters 23 and 24 can be found at www.prenhall.comlkeown

23-1

xv


CHAPTER 1
AN I NTRO DUCTI 0 N
TO FINANCIAL
MANAGEMENT

CHAPTER 2
UNDERSTANDING
FINANCIAL
STATEMENTS, TAXES,
AND CASH FLOWS

CHAPTER 3
EVALUATI NG A
FIRM'S FINANCIAL
PERFORMANCE

CHAPTER 4
FI NAN CIAL
FORECASTING,
PLANNING, AND
BUDGETING



CHAPTER 1


An Introd uction
to Financial Management

In 1985, Harley-Davidson teetered only hours away from bank­

a successful stock offering, and Spring 2003, Harley's stock

ruptcy as one of Harley's largest lenders, Citicorp Industrial

price rose approximately 125-fold. How did Harley-Davidson, a

Credit, was considering bailing out on its loan. Since its begin­

company whose name grown men and women have tattooed

ning in 1903, the company survived two world wars, the Great

on their arms and elsewhere, a company that conjures up

Depression, and competition from countless competitors, but

images of burly bad boys and Easy Rider hippies in black leather

by the early 1980s, Harley had become known for questionable

jackets riding down the road, pull off one of the biggest busi­

reliability and leaving oil stains on people's driveways. It looked

ness turnarounds of all time? Harley made good decisions.

for a while like the future was set, and Harley wouldn't be

That's what we're going to look at in this book. We'll look at

there. It looked like the future of motorcycles in America would

what it takes to turn Harley or any other company around.

feature only Japanese names like Honda, Yamaha, Kawasaki,

We'll look at how a company goes about making decisions to

and Suzuki. But none of that happened, and today Harley­

introduce new product lines. For example, in 2003, Harley­

Davidson stands, as President Reagan once proclaimed, as "an

Davidson introduced the Buell Lightning Low XB95, a low-cost,

American success story." For a company in today's world, sur­

lightweight bike with a lower seat height aimed at bringing

viving one scare is not enough-Today the business world
involves a continuous series of challenges. As for Harley, it was

shorter riders into the sport. How did it make this decision?

a major accomplishment to make it through the 1980s, allow­

ining how its experience fits in with the topics we are examin­

We'll also follow Harley-Davidson throughout this book, exam­

ing it to face another challenge in the 1990s: a market that

ing. In doing so, we will see that there are countless interac­

looked like it might disappear within a few years. How did

tions among finance, marketing, management, and accounting.

Harley do against what looked like a shrinking market? It

Because finance deals with decision making, it takes on impor­

increased its motorcycle shipments from just over 60,000 in

tance, regardless of your major. Moreover, the tools, techniques,

1990 to over 260,000 in 2002 with expected sales in 2003 of

and understanding you will gain from finance will not only help

around 290,000! How have the shareholders done? Between

you in your business career, but will also help you make edu­

1986, when Harley-Davidson returned to public ownership with

cated personal investment decisionsin the future.

~

CHAPTER PREVIEW

In this chapter, we will lay a foundation for the entire
book. We will explain what finance is, and then we
will explain the key goal that guides financial deci­
sion making: maximization of shareholder wealth.
We will examine the legal environment of financial

~

decisions. Then, we will describe the golden thread
that ties everything together: the 10 basic principles

of finance. Finally, we will look at the importance of
looking beyond our geographic boundaries.

3


4

PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT

Objective ~

WHAT IS FINANCE?
Financial management is concerned with the maintenance and creation of economic
value or wealth. Consequently, this course focuses on decision making with an eye toward
creating wealth. As such, we will deal with financial decisions such as when to introduce a
new product, when to invest in new assets, when to replace existing assets, when to bor­
row from banks, when to issue stocks or bonds, when to extend credit to a customer, and
how much cash to maintain.
To illustrate, consider two firms, Merck and General Motors (GM). At the end of
2003, the total market value of Merck, a large pharmaceutical company, was $103 billion.
Over the life of the business, Merck's investors had invested about $30 billion in the busi­
ness. In other words, management created $73 billion in additional wealth for the share­
holders. GM, on the other hand, was valued at $30 billion at the end of 2003; but over the
years, GM's investors had actually invested $85 billion-a loss in value of $55 billion.
Therefore, Merck created wealth for its shareholders, while GM lost shareholder wealth.
In introducing decision-making techniques,we will emphasize the logic behind those
techniques, thereby ensuring that we do not lose sight of the concepts when dealing with
the calculations. To the first-time student of finance, this may sound a bit overwhelming.
However, as we will see, the techniques and tools introduced in this text are all motivated by

10 underlying principles or axioms that will guide us through the decision-making process.

Objective ~

GOAL OF THE FIRM
We believe that the preferable goal of the firm should be maximization of shareholder
wealth, by which we mean maximization of the price of the existing common stock. Not
only will this goal be in the best interest of the shareholders, but it will also provide the
most benefits to society. This will come about as scarce resources are directed to their
most productive use by businesses competing to create wealth.
To better understand this goal, we will first discuss profit maximization as a possible
goal for the firm. Then we will compare it to maximization of shareholder wealth to see
why, in financial management, the latter is the more appropriate goal for the firm.

PROFIT MAXIMIZATION
In microeconomics courses, profit maximization is frequently given as the goal of the
firm. Profit maximization stresses the efficient use of capital resources, but it is not spe­
cific with respect to the time frame over which profits are to be measured. Do we maxi­
mize profits over the current year, or do we maximize profits over some longer period? A
financial manager could easily increase current profits by eliminating research and devel­
opment expenditures and cutting down on' routine maintenance. In the short run, this
might result in increased profits, but this clearly is not in the best long-run interests of the
firm. If we are to base financial decisions ona goal, that goal must be precise, not allow
for misinterpretation, and deal with all the complexities of the.real world.
In microeconomics, profit maximization functions largely as a theoretical goal, with
economists using it to prove how firms behave rationally to increase profit. Unfortunately,
it ignores many real-world complexities that financial managers must address in their deci­
sions. In the more applied discipline of financial management, firms must deal every day
with two major factors not considered by the goal of profit maximization: uncertainty and
timing.

Microeconomics courses ignore uncertainty and risk to present theory more easily.
Projects and investment alternatives are compared by examining their expected values or


CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT

weighted average profits. Whether one project is riskier than another does not enter into
these calculations; economists do discuss risk, but only tangentially.! In reality, projects
differ a great deal with respect to risk characteristics, and to disregard these differences in
the practice of financial management can result in incorrect decisions. As we will discover
later in this chapter, there is a very definite relationship between risk and expected
return-that is, investors demand a higher expected return for taking on added risk-and
to ignore this relationship would lead to improper decisions.
Another problem with the goal of profit maximization is that it ignores the timing of
the project's returns. If this goal is only concerned with this year's profits, we know it
inappropriately ignores profit in future years. If we interpret it to maximize the average of
future profits, it is also incorrect. Inasmuch as investment opportunities are available for
money in hand, we are not indifferent to the timing of the returns. Given equivalent cash
flows from profits, we want those cash flows sooner rather than later. Thus the real-world
factors of uncertainty and timing force us to look beyond a simple goal of profit maxi­
mization as a decision criterion.
Finally, and possibly most important, accounting profits fail to recognize one of the
most important costs of doing business. When we calculate accounting profits, we con­
sider interest expense as a cost of borrowing money, but we ignore the cost of the funds
provided by the firm's shareholders (owners). If a company could earn 8 percent on a new
investment, that would surely increase the firm's profits. However, what if the firm's
shareholders could earn 12 percent with that same money in another investment of simi­
lar risk? Should the company's managers accept the investment because it will increase
the firm's profits? Not if they want to act in the best interest of the firm's owners (share­
holders). Now look at what happened with Burlington Northern.

Burlington Northern is a perfect example of erroneous thinking. In 1980, Richard
Bressler was appointed as Chief Executive Officer (CEO) of the company. Bressler,
unlike his predecessor, was not a "railroad man." He was an "outsider" who was hired for
the express purpose of improving the value of the shareholders' stock. The reason for the
change was that Burlington Northern had been earning about 4 percent on the share­
holders' equity, when Certificates of Deposit (CDs) with no risk were paying 6 percent.
Management was certainly increasing the firm's profits, but they were destroying share­
holder wealth by investing in railroad lines that were not even earning a rate of return
equal to that paid on government securities. We will turn now to an examination of a
more robust goal for the firm: maximization of shareholder wealth.
-~

MAXIMIZATION OF SHAREHOLDER WEALTH
In formulating the goal of maximization of shareholder wealth, we are doing nothing
more than modifying the goal of profit maximization to deal with the complexities of the
operating environment. We have chosen maximization of shareholder wealth-that is,
maximization of the market value of the existing shareholders' common stock-because
the effects of all financial decisions are thereby included. Investors react to poor invest­
ment or dividend decisions by causing the total value of the firm's stock to fall, ano they
react to good decisions by pushing up the price of the stock. In effect, under this goal,
good decisions are those that create wealth for the shareholder.
Obviously, there are some serious practical problems in implementing this goal and
in using changes in the firm's stock to evaluate financial decisions. We know the price of
a firm's stock fluctuates, often for no apparent r('ason. However, over the long run, price
equals value. We will keep this long-run balancing in mind and focus on the effect that

I:

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I See, for example, Robert S. Pindyck and Daniel Rubenfield, MiC7'OecQlwlIIics, 2d ed. (New York: MacmiUan, !992),
244--46.

5


6

PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT

FINANCE
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ETHICS

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'THE ENRON LESSONS
On December 2, 2001 the Enron Corporation (Houston,
TX) declared bankruptcy. Enron's failure shocked the busi­
ness community because of the size and prominence of the
finn. Perhaps most telling is the fact that Enron Corp. had
been named the most innovative company in America by
F01tune Magazine for six srraight years, with the most recent
award being made in January 2001. The Enron failure dom­
inated the financial press for months thereafter and also
resulted in a series of high profile congressional hearings.
Throughout this book we will be presenting the lessons
learned from Enron in a series of boxes, but first, here is an
assessment of why there was so much public concern over
the event.
In a capitalistic economy firms are formed by enrre­
preneurs-some grow to be large, publicly traded firms
like Enron, and many of them eventually fail. So why is
the failure of Enron so important? After all, failure is just
evidence of the Darwinian survival of the fittest principle
at work, right? However, the Enron situation seems to be
different. Let's consider some of the reasons why the
Enron case might be special and see if they can explain
the public rancor over the firm's failure.

This Was the Largest Bankruptcy Ever"
True, Enron's bankruptcy is the largest such bankruptcy ever
with a total of $63 billion in equity value vaporized in a
12-month period. But this loss of shareholder value is far

from the largest such loss of value ever. Consider the fact
that the following list of firms have lost more than twice the
shareholder value that Enron lost: AOL Time Warner,
Cisco, EMC, Intel, JDS Uniphase, Lucent, Microsoft,
Nortel, Sun Microsystems, and Worldcom. In fact, the value
of Cisco's equity fell a mind boggling $423 billion compared
to Enron's meager $63 billion. But since Enron lost every­
thing, that's different, right? Global Crossings also lost

everything (more than $48 billion), and there was not nearly .
the public outcry over this bankruptcy.

Failure of the Public Reporting Process
What we've learned about the deep seeded problems at
Enron after the firm's failure has led many investors to ques­
tion the adequateness of public reporting. For example,
where were the analysts and credit rating agencies, since no
early warning was sounded? Where were the firm's auditors
and why were they not reporting what appear in hindsight to
be a blatant disregard for standard reporting practice to the
board of director's auditor committee? Speaking of which,
where was the firms board of directors and why were they
not questioning some of Enron's related party rransactions?
It would appear that an important source of the public
outcry associated with the failure of Enron comes from the
fact that this failure provides a clear warning as to just what
can happen. Investor confidence in the system of public
reporting has been shaken. If the most innovative company
in America for six straight years and' the darling of Wall
Srreet can be this close to bankruptcy and no one seems to

notice, what about less notable firms?
Political Influence, Fraud, and Scandal
Even the National Enquirer devoted its cover story to
Enron. b Add the prospect of criminal wrongdoing by
Enron's executives to the fact that Enron was a major con­
tributor to both political parties (although its ties to the
Republican party are better known) and you have the stuff of
which good soap opera plots are made.
"From "More Reasons ro Get Riled Up," Geoffrey Colvin, Fortllne (3/4/02).
© 2002 Time, Inc. All Rights Reserved.
bKevin Lynch, Michael Hanrahan, and David Wrighr, "Enron: The Untold
Srory," The NlTtirmal Enqllirer (February 26,2002).

our decision should have on the stock price if everything else were held constant. The
market price Of the firm's stock reflects the value of the firm as seen by its owners and
takes into account the complexities and complications of the real-world risk. As we follow
this goal throughout our discussions, we must keep in mind that the shareholders are the
legal owners of the firm. See the Finance Matters box, "Ethics: The Enron Lessons."

CONCEPT CHECK
1.

What are the problems with the goal of profit maximization?

2.

What is the goal of the firm?
-

-

!
I


CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT

LEGAL FORMS OF BUSINESS ORGANIZATtON

Objective

7

-.!J

In the chapters ahead, we will focus on financial decisions for corporations. Although the
corporation is not the only legal form of business available, it is the most logical choice
for a firm that is large or growing. It is also the dominant business form in terms of sales
in this country. In this section, we will explain why this is so. This will in turn allow us to
simplify the remainder of the text, as we will assume that the proper tax code to follow is
the corporate tax code, rather than examine different tax codes for different legal forms of
businesses. Keep in mind that our primary purpose is to develop an understanding of the
logic of financial decision making. Taxes will become important only when they affect our
decisions, and our discussion of the choice of the legal form of the business is directed at
understanding why we will limit our discussion of taxes to the corporate form.
Legal forms of business organization are diverse and numerous. However, there are
three categories: the sole proprietorship, the partnership, and the corporation. To
understand the basic differences between each form, we need to define each form and
understand its advantages and disadvantages. As we will see, as the firm grows, the
advantages of the corporation begin to dominate. As a result, most large firms take on

the corporate form.
SOLE PROPRIETORSHIP
The sole proprietorship is a business owned by a single individual. The owner maintains title to the assets and is personally responsible, generally without limitation, for the
liabilities incurred. The proprietor is entitled to the profits from the business but must
also absorb any losses. This form of business is initiated by the mere act of beginning the
business operations. Typically, no legal requirement must be met in starting the operation, particularly if the proprietor is conducting the business in his or her own name. If a
special name is used, an assumed-name certificate should be filed, requiring a small registration fee. Termination occurs on the owner's death or by the owner's choice. Briefly
stated, the sole proprietorship is, for all practical purposes, the absence of any formal!ega!
business structure.

Sole proprietorship

t:- business owned by a single
indiVIdual.
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PARTNERSHIP
The primary difference between a partnership and a sole proprietorship is that the part­
nership has more than one owner. A partnership is an association of two or more persons
coming together as co-owners for the purpose of operating a business for profit.
Partnerships fall into two types: (1) general partnerships and (2) limited partnerships.

Partnership
An association of two or more

individuals joining together as
co-owners to operate a business
for profit.

GENE RAL PA RTNERSHIP In a general partnership, each partner is fully responsible
for the liabilities incurred by the parmership. Thus, any parmer's faulty conduct even

having the appearance of relating to the firm's business renders the remaining partners
liable as well. The relationship among parmers is dictated entirely by the partnership
agreement, which may be an oral commitJnent or a formal document.

LIMITED PARTNERSHIP AND LIMITED LIABILITY COMPANY Inadditionto
the general partnership, in which all partners are jointly liable without limitation, many
states provide for a limited partnership. The state statutes permit one or more of the part­
ners to have limited liability, restricted to the amount of capital invested in the partner­
ship. Several conditions must be met to qualify as a limited parmer. First, at least one
general partner must remain in the association for whom the privilege of limited liability
does not apply. Second, the names of the limited partners may not appear in the name of

j


8

PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT

Limited liability company
(LLC)
An organizational form that is a
cross between a partnership
and a corporation.

the firm. Third, the limited partners may not participate in the management of the busi­
ness. If one of these restrictions is violated, all partners forfeit their right to limited liabil­
ity. In essence, the intent of the statutes creating the limited partnership is to provide lim­
ited liability for a person whose interest in the partnership is purely as an investor. That
individual may not assume a management function within the organization.

A limited liability company (LLC) is a cross between a partnership and a corpora­
tion. It retains limited liability for its owners, but is run and taxed like a partnership. Both
states and the IRS have rules for what qualifies as an LLC, but the bottom line is that it
must not look too much like a corporation or it will be taxed as one.

CORPORATION
Corporation
An entity that legally functions
separate and apart from its
owners.

The corporation has been a significant factor in the economic development of the
United States. As early as 1819, ChiefJustice John Marshall set forth the legal definition
of a corporation as "an artificial being, invisible, intangible, and existing only in the con­
templation of law."2 This entity legally functions separate and apart from its owners. As
such, the corporation can individually sue and be sued, and purchase, sell, or own prop­
erty; and its personnel are subject to criminal punishment for crimes. However, despite
this legal separation, the corporation is composed of owners who dictate its direction and
policies. The owners elect a board of directors, whose members in turn select individuals
to serve as corporate officers, including president, vice president, secretary, and treasurer.
Ownership is reflected in common stock certificates, designating the number of shares
owned by its holder. The number of shares owned relative to the total number of shares
outstanding determines the stockholder's proportionate ownership in the business.
Because the shares are transferable, ownership in a corporation may be changed by a
shareholder simply remitting the shares to a new shareholder. The investor's liability is
confined to the amount of the investment in the company, thereby preventing creditors
from confiscating stockholders' personal assets in settlement of unresolved claims. This is
an extremely important advantage of a corporation. After all, would you be willing to
invest in General Electric if you would be liable in the event that one of their airplane
engines malfunctions and people die in a crash? Finally, the life of a corporation is not

dependent on the status of the investors. The death or withdrawal of an investor does not
affect the continuity of the corporation. The management continues to run the corpora­
tion when stock is sold or when it is passed on through inheritance. See the Finance
Matters box, "Ethics: The Enron Lessons."

COMPARISON OF ORGANIZATIONAL FORMS
Owners of new businesses have some important decisions to make in choosing an organi­
zational form. Whereas each business form seems to have some advantages over the oth­
ers, we will see that, as the firm grows and needs access to the capital markets to raise
funds, the advantages of the corporation begin to dominate.
Large and growing firms choose the corporate form for one re~son: ease in raising
capital. Because of the limited liability, the ease of transferring ownership through the
sale of common shares, and the flexibility in dividing the shares, the corporation is the
ideal business entity in terms of attracting new capital. In contrast, the unlimited liabili':
ties of the sole proprietorship and the general partnership are deterrents to raising equity
capital. Between the extremes, the limited partnership does provide limited liability for
limited partners, which has a tendency to attract wealthy investors. However, the imprac­
1

Tbe Trustees ofDm'tmrJUtb College v. Woodward, 4 Wheaton 636 (1819).


CHAPTER

AN INTRODUCTION TO FINANCIAL MANAGEMENT

THE ENRON LESSONS
The bankruptcy and failure of the Enron Corporation on
December 2, 2001 shook the investment community to
its very core and resulted in congressional hearings that

could lead to new regulations with far reaching implications. Enron's failure provides a sober warning to
employees and investors and a valuable set of lessons for
students of business. The lessons we offer below reach far
beyond corporate finance and touch on fundamental
principles that have always been true, but that are sometimes forgotten.
Lesson: Maximizing Share Value Is Not Always
the BeSt Thing to Do
If there is a disconnect between current market prices and
the intrinsic worth of a firm then attempts to manipulate
share value may appear to be possible over the short run.
Under these circumstances problems can arise if firms use
equity-based compensation based on performance benchmarks using stock price or returns. These circumstances can

lead to a type of managerial short-sightedness or myopia
that focuses managerial attention on "hyping" the firm's
potential to investors in an effort to reach higher market valuations of the firm's stock.
From the shareholder's perspective one might ask what is
wrong with achieving a higher stock price? The problem is
that this can lead to a situation where investor expectations
become detached from what is feasible for the firm.
Ultimately, when investors realize that the valuation of the
firm's shares is unwarranted, there is a day of reckoning that
can bring catastrophic consequences as it did with Enron.
Thus, maximizing share value where the firm's underlying
fundamentals do not support such valuations is dangerous
business. In fact, it is not clear which is worse, having an
over- or an undervalued stock price.
The problems associated with ma.naging for shareholder
value in a capital market that is less than omniscient (perfectly efficient) is largely uncharted territOly for financial
economists.

ticality of having a large number of partners and the restricted marketability of an interest in a partnership prevent this form of organization from competing effectively with the
corporation. Therefore, when developing our decision models, we will assume that we
are dealing with the corporate form. The taxes incorporated in these models will deal
only with the corporate tax codes. Because our goal is to develop an understanding of the
management, measurement, and creation of wealth, and not to become tax experts, in the
following chapter we will only focus on those characteristics of the corporate tax code
that will affect our financial decisions.

THE ROLE OF THE FINANCIAL MANAGER
IN A CORPORATION
Although a firm can assume many different organizational structures, Figure 1-1 presents
a typical representation of how the finance area fits into a corporation. The Vice
President for Finance, also called the Chief Financial OffIcer (CFO), serves under the
corporation's Chief Executive Officer (CEO) and is responsible for overseeing financial
planning, corporate strategic planning, and controlling the firm's cash flow. Typically, a
Treasurer and Controller serve under the CFO. In a smaller firm, the same person may
fill both roles, with just one office handling all the du.ties. The Treasurer generally handles the firm's financial activities, including cash and credit management, making capital
expenditure decisions, raising funds, financial planning, and managing any foreign currency received by the firm. The Controller is responsible for managing the firm's
accounting duties, including producing financial swtements, cost accounting, paying
taxes, and gathering and monitoring the data necessary to oversee the firm's financial
well-being. In this class, we focus on the duties generally associated with the Treasurer
and on how investment decisions are made.

9


10

PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT

FIGURE 1-1

How the Finance Area Fits into a Corporation

Board of Directors
Chief Executive Officer
(CEO)

::=J
Vice PresidentMarketing

Vice President-Finance
or
ChiefFinanciaI Officer (CFO)

Vice PresidentProduction and Operations

Duties:

Oversee financial planning
Corporate strategic planning
Control corporate cash flow

Treasurer

Controller

Duties:
Cash management

Credit management
Capital expenditures
Raising capital
Financial planning
Management of foreign currencies

Duties:
Taxes
Financial statements
Cost accounting
Data processing

CONCEPT CHECK

1.
2.
3.

What are the primary differences among a sole proprietorship, a
partnership, and a corporation?
Explain why large and growing firms tend to choose the corporate
form.
What are the duties of the Corporate Treasurer? Of the Corporate
Controller?
-

-

-

-"-

I

-"

-

--

I

THE CORPORATION AND THE FINANCIAL MARKETS:
THE INTERACTION
Without question, the ease of raising capital is the major reason for the popularity of the
corporate form. While we will look at the process of raising capital in some detail in
Chapter 14, let's spend a moment looking at the flow of capital through the financial markets among the corporation, individuals, and the government.
Figure 1-2 examines these flows. (1) Initially, the corporation raises funds in the financial markets by selling securities. The corporation receives cash in return for securitiesstocks and debt. (2) The corporation then invests this cash in return-generating assetsnew projects for example-and (3) the cash flow from those assets is then either reinvested


CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT

FIGURE 1-2

11

The Corporation and the Financial Markets: The Interaction

1. Initially, the corporation raises funds in the financial markets by selling securities-stocks and bonds; 2. The
corporation then invests this cash in return-generating assets-new project; 3. The cash flow from those assets is either

reinvested in the corporation, given back to the investors, or paid to the government in the form of taxes.
1.

Primary Markets
Corporation

Investors

Cash

Securities

2.
Corporation

invests
in returngenerating
assets

Cash reinvested
in the corporation

Secondaty
markets

o

Securities traded

3.

Cash distributed
back to investors

Cash flow from
operations

among investors

Taxes

('rl)vernment

in the corporation; given back to the investors in the form of dividends or interest payments, or used to repurchase stock, which should cause the stock price to rise; or given to
the government in the form of tax payments.
One distinction that is important to understand is the difference between primary
and secondary markets. Again, we will reexamine raising capital and the difference
between primary and secondary markets in some detail in Chapter 14. To begin with, a
securities market is simply a place where you can buy or sell securities. These markets can
take the form of anything from an actual building on Wall Street in New York City to an
electronic hookup among security dealers all over the world. Securities markets are
divided into primary and secondary markets. Let's take a look at what these terms mean.
A primary market is a market in which new, as opposed to previously issued, securities are traded. This is the only time that the issuing firm actually receives money for it~
stock. For example, if Nike issues a new batch of stock, this issue would be considered a
primary market transaction. In this case, Nike would issue new shares of stock and receive
money from investors. Actually, there are two different types of {)fferings in the primary
markets: initial public offerings and seasoned new issues or primary offerings. An initial
public offering (IPO) is the first time the company's stock is sold to the general public,
whereas a seasoned new issue refers to stock offerings by companies that already have
common stock traded in the secondary market. Once the newly issued stock is in the public's hands, it then begins trading in the secondary market. Securities that have previously been issued and bought are traded in the secondary market. For example, if you
bought 100 shares of stock in an IPO and then wanted to resell them, you would be

reselling them in the secondary markets. The proceeds from the sale of a share of IBM
stock in the secondary market go to the previous owner of the stock, not to IBM. That is
because the only time IBM ever receives money from the sale of one of its securities is in
the primary markets.

Primary market
A market in which new, as
opposed to previously issued,
securities are traded.

Initial public offering' (lPO)
The first time the company's
stock is sold to the public.

Seasoned new issue
Stock offerings by companies
that already have common
stock traded.

Secondary market
The market in which stock
previously issued by the firm
trades.


12

PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT

AN INTERVIEW WITH JEFF BlEUSTEIN. HARlEY-DAVIDSON'S CEO

Jeff Bleustein is the Chief Executive Officer at HarleyDavidson Company, Inc. In our interview with Mr. Bleustein,
he highlighted a number of milestones that he believes have
greatly influenced the company's success over the past two
decades. Much of what he had to say related directly to the
main topics of this book. Specifically, he talked about the
company's strategies in the areas of investment decisions,
working-capital management, financing decisions, marketing
strategies, and global expansion. He also emphasized the
importance of the people who implement these decisions. He
insists that there is more to business than crunching the numbers; it is people that make the difference. Mr. Bleustein's
remarks can be summarized as follows:
• In 1981, the management of Harley-Davidson bought
the company from its parent company, ANIF, in a leveraged buyout. The extremely high level of debt incurred
to finance the purchase placed the company in a very frail
financial condition. The downturn in the economy, combined with the debt load, created a powerful incentive to
improve operations to conserve cash. To add to the problems, the firm's principal lender, Citibank, announced in
1985 that it wanted out of its creditor position for the
firm. Last-minute refinancing was arranged on
December 31, 1985 to save the company from bankruptcy. Then, within a few short months the company's
financial picture had improved to the point where we
were able to take the company public in an initial public
offering.
• During the past two decades, the company has made significant capital investments in new product lines, such as
the Evolution engine, the Softail motorcycle, and most
recently, the Twin Cam 88 engine, one of our current
engine designs. Also, in 1998 we invested in new manufacturing facilities in Kansas City, Missouri, and
Menominee Falls, ·Wisconsin.
• To improve the film's management of its working capital,
we introduced the use of just-in-time inventory conu·ol.
We called our program MAN, which stands for Materials

As Needed. This program allowed us to remove $51 million from our work-in-process inventory and provided

Objective

--.!J

•

•

•

•

•

much-needed capital to support our operations while we
paid on the firm's large amounts of debt.
In 1983, we established our Harley Owner's Group
(HOG) to encourage our customers to use their bikes
and stay illYolved with the company. At the end of 2000,
we had nearly 600,000 members. We also began a program of carefully managing the licensing of the HarleyDavidson name.
In the 1980s, we began a program to empower our
employees. We needed to let everyone in the organization
know what was expected of him or her, which led us to the
development of our corporate vision and statement ofvalues! I strongly believe that the only sustainable corporate
advantage a company can have is its people.
In 1994, we began fostering a partnership with our
unions to enable them to participate fully in the business.
Today our two unions participate fully with the firm's

management in a wide range of decision making, including the firm's strategies.
\Ve also initiated our circle organization, which involves
the use of a team structure at our vice president level of
management to make the decisions. As a result, we eliminated a whole layer from top management.
Beginning in the 19905, we entered into a serious effort to
globalize the company. We established a management team
in Europe, and over time we acquired our independent distributors in major market~, such as the BenelufX, and Italy.

All of these decisions have significant financial implications
that are tied to our study of finance. Specifically, they reflect
financing choices, investment decisions, and workingcapital management. So, we invite you to join us in our study
of finance and, in the process, learn about a company that
has accomplished in real terms what few others 'have been
able to eLl.
'Harley-D;lvidson Motor Company:' mission statement is, ""Ve fulfill
dreams through the experiences of motorcycling by providing to motorcyclists and the general public an expanding line of motorcycles, branded
products and services in selected market segments. The firm's value statement is exprcssed as, 'Tell the tmth, be fair, keep your promises, respect the
individual, and encourage intellectual curiosity.'''

TEN PRINCIPLES THAT FORM THE BASICS
OF FINANCIAL MANAGEMENT
We will now look at the finance fow1dations that lie behind the decisions made by financial managers. To the first-time student of finance, the subject matter may seem like a collection of unrelated decision rules. This could not be further from the truth. In fact, our


CHAPTER 1 AN INTRODUCTION TO FINANCIAL MANAGEMENT

decision rules, and the logic that underlies them, spring from 10 simple principles that do
not require knowledge of finance to understand. However, while it is not necessary to understandfinance in order to understand these priluiples, it is necessary to understand these principles
in order to understand finance. Keep in mind that although these principles may at first
appear simple or even trivial, they will provide the driving force behind all that follows.

These principles will weave together concepts and techniques presented in this text,
thereby allowing us to focus on the logic underlying the practice of financial management. In order to make the learning process easier for you as a student, we will keep
returning to these principles throughout the book in the form of "Back to the Principles"
boxes-tying the material together and letting you son the "forest from the trees."

PRINCIPLE

The Risk-Return Trade-Oft-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 conswnption opportunities-for example, save for a house,
a car, or retirement. We are able to invest those savings and earn a return on our dollars
because some people would rather 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 that
would like to use our savings, how do we decide where to put our money?
First, investors demand a minimum return for delaying conswnption 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 conswnption if your savings are
going to decline in terms of purchasing power.
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. The more risk an investment has, the higher
will be its expected return. This relationship between risk and expected return is shown
in Figure 1-3.

FIGURE 1-3

The Risk-Return Relationship

aE~

-g

Expected return
for taking on
} added risk

t
:
Expected return {
for delaying
consumption
LI

_

Risk

13


14

PART 1 THE SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT

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 peer into the
future and see what those rerurns are actually going to be. If investors could see into the
future, no one would have invested money in the software maker Citrix, whose stock
dropped 46 percent on June 13, 2000. Citrix's stock dropped when it announced that
unexpected problems in its sales channels would cause second-quarter profits to be about
half what Wall Street expected. Until after the fact, you are never sure what the return on
an investment will be. That is why General Motors bonds pay more interest than U.S.
Treasury bonds of the same maturity. The additional interest convinces some investors to
take on the added risk of purchasing a General Motors bond.
This risk-return relationship will be a key concept as we value stocks, bonds, and
proposed new projects throughout this text. We will 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 1-3 and how to measure risk.
Both the graph and the risk-return relationship it depicts will 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

A fundamental concept in finance is that 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 opporrunity 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 will 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 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.
---.,

PRINC I PLE

3

Cash-Not Profits-Is King

In measuring wealth or value, we will use cash flows, not accounting profits, as our measurement tool. That is, we will be concerned with when the money hits our 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 the cash flows, not profits, that
are actually received by the firm and can be reinvested. Accounting profits, however,
appear 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 be the same. For example, a capital
expense, such as the purchase of new equipment or a building, is depreciated over several years, wjth the annual depreciation subtracted from profits. However, the cash flow,
or actual dollars, associated with this expense generally occurs immediately. Therefore


CHAPTER"l

AN INTRODUCTION TO FINANCIAL MANAGEMENT

cash inflows and outflows involve the actual receiving and payout of money-when the
money hits or leaves your hands. As a result, cash flows correctly reflect the timing of the
benefits and costs.

PRINCIPLE

4

Incremental Cash Flows-it's only what changes that
counts

In 2000, Post, the maker of Cocoa Pebbles and Fruity Pebbles, introduced Cinna Crunch
Pebbles, "Cinnamon sweet taste that goes crunch." There is no doubt that Cinna Crunch
Pebbles competed directly with Post's other cereals and, in particular, its Pebbles products. Certainly some of the sales dollars that ended up with Cinna Crunch Pebbles would
have been spent on other Pebbles and Post products if Cinna Crunch Pebbles had not
been available. Although Post was targeting younger consumers with this sweetened
cereal, there is no question that Post sales bit into-actually cannibalized-sales from
Pebbles and other Post lines. Realistically, there's only so much cereal anyone can eat.
The difference between revenues Post generated after introducing Cinna Crunch Pebbles
versus simply maintaining its existing line of cereals is the incremental cash flows. This
difference reflects the true impact of the decision.
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 only consider 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.
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, we will 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 will look closely at the
mechanics of valuation and decision making. We will focus on estimating cash flows,
determining what the investment earns, and valuing assets and new projects. But it will be
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 evaluating profitable projects than finding them. If an
industry is generating large profits, new entrants are usually attracted. The additional
competition and added capacity can result in profits being driven down to the required
rate of return. Conversely, if an industry is returning profits below the required rate of
return, then some participants in the market drop out, reducing capacity and competition. In turn, 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 with firms moving out of the video rental industry, profits again rose to the point
where the required rate of return could be earned on invested capital.

15