Tenth Edition F INANCIAL ANAGEMENT AND OLICY James C. Van Horne Stanford University Prentice Hall, Englewood Cliffs, New Jersey 07632,chapter GOALS AND FUNCTIONS OF FINANCE "Toe moden-day financial manajer instrumental compar’ secs. As cashflows pate through the organization, this individual is atthe beart of what is happening. If finance is to play 4 general management roe in the organization, the financial manager must be a team player whois constructively involved in operations, marketing, and the company’s osrall strategy. Where once the financial manager was charged only with such routine tasks as keeping records, preparing Jinancial reports, managing the company’s casb position, paying bills, and, on occasion, obtaining ‘funds, the broad domain today includes (4) inoestment i assets and wew products and (2) deter mining the best mix of financing and dividends i relation toa company’s overall valuation “Investment of funds in assets determines the size ofthe frm, ils profits from operations, its business risk, and its liquidity. Obtaining the best mix of nancing and dividends determines the firm’: financial charges and its financial rich, it also impacts its valuation. All of this demands a broad outlook and an alert creatiity that will nfuence almost al facets ofthe enterprise. Creation of Value ‘The objective of a company must be to create value for its shareholders. Value is rep- resented by the market price of the company’s common stock, which, in turn is a function of the firm’ investment, financing, and dividend decisions. The idea is to acquire assets and invest in new products and services where expected return exceeds their cost, to finance with those instruments where there is particular advantage, tax or otherwise, and to undertake a meaningful dividend policy for stockholders. Throughout this book, the unifying theme is value creation. This occurs when you do something for your sharebolders that they cannot do for thenseloes. It may be that a company enjoys a favorable niche in an attractive industry, and this permits it to earn returns in excess of what the financial markets require for the risk involved. Perhaps the financial manager is able to take advantage of imperfections in the financial markets and acquire capital on favorable terms. If the financial markets are highly efficient, as they are in many countries, we would expect the former to be a wider avenue for value creation than the latter. Most shareholders are unable to develop products on their own, so value creation here certainly is 2Chapter 1 2 Goals and Functions of Finance 3 possible. Contrast this with diversification, where investors are able to diversify the securities they hold, Therefore, diversification by a company is unlikely to create much, if any, value. Profit Maximization Versus Value Creation Frequently, maximization of profits is regarded as the proper objective of the firm, but it is not as inclusive a goal as that of maximizing shareholder value, For one thing, total profits are not as important as earnings per share. A firm could always raise total profits by issuing stock and using the proceeds to invest in Treasury bills. Even maximization of earnings per share, however, is not a fully appropriate objective, partly because it does not specify the timing or duration of expected returns, Is the investment project that will produce a $100,000 return 5 years from now more valuable than the project that will produce annual returns of $15,000 in each of the next 5 years? An answer to this question depends on the time value of money. Few stockholders would think favorably of a project that promised its first return in 100 years, no matter how large the return. We must take into account the time pattern of returns in our analysis. Another shortcoming of the objective of maximizing earnings per share is that it does not consider the risk or uncertainty of the prospective earnings stream. Some investment projects are far more risky than others. As a result, the prospective stream of earnings per share would be more uncertain if these pro- jects were undertaken. In addition, a company will be more or less risky depend- ing on the amount of debt in relation to equity in its capital structure. This finan- cial risk is another uncertainty in the minds of investors when they judge the firm in the marketplace. Finally, an earnings per share objective does not take into account any dividend the company might pay. For the reasons given, an objective of maximizing earnings per share may not be the same as maximizing market price per share. The market price of a firm’s stock represents the value that market participants place on the firm. Agency Problems ‘The objectives of management may differ from those of the firm’ stockholders. Ina large corporation, the stock may be so widely held that stockholders cannot, even make known their objectives, much less control or influence management. Often ownership and control are’separate, a situation that allows management to act in its own best interests rather than those of the stockholders. We may think of management as agents of the owners. Stockholders, hoping that the agents will actin the stockholders’ best interests, delegate decision-making authority to them. Jensen and Meckling were the first to develop a comprehensive agency theory of the firm,* They show that the principals, in our case the stockhold- ers, can assure themselves that the agent (management) will make optimal decisions only if appropriate incentives are given and only if the agent is monitored. Incentives include stock options, bonuses, and perquisites, and they are directly related to how close management decisions come to the interests of stockholders. "Michael © Jensen and Willam H. Meckling, “Theory ofthe Fm: Managerial Behavior, Agency Coss sand Ownership Structure,” Jomal of Fhxcial avons, 3 (October 1976), 308-60,4 Part 1% Foundations of Finance Monitoring can be done by bonding the agent, systematically reviewing management perquisites, auditing financial statements, and explicitly limiting management decisions. These monitoring activities necessarily involve costs, an inevitable result of the separation of ownership and control of a corporation. The less the ownership percentage of the managers, the less the likelihood that they will behave in a manner consistent with maximizing sharcholder wealth and the greater the need for outside stockholders to monitor their activities. Agency problems also arise in creditors and equityholders having different objectives, thereby causing each party to want to monitor the others. Similarly, other stakeholders—employces, suppliers, customers, and communities—may have different agendas and may want to monitor the behavior of equityholders and management. Agency problems occur in investment, financing, and di dend decisions by a company, and we will discuss them throughout the book. ng A Normative Goal Because the principle of maximization of shareholder wealth provides a rational guide for running a business and for the efficient allocation of resources in society, ‘we use it as our assumed objective in considering how financial decisions should be made, The purpose of capital markets isto allocate savings efficiently in an econ- ‘omy, from ultimate savers to ultimate users of funds who invest in real assets If sav- ings are to be channeled to the most promising investment opportunities, a rational ‘economic criterion must govern their flow. By and large, the allocation of savings in an economy occurs on the basis of expected return and risk. [he market value of a company’s stock, embodying both of these factors, therefore reflects the markets trade-off bebween risk and return, If decisions are made in keeping with the likely effect on the market value of its stock, a firm will attract capital only when its investment opportunities justify the use of that capital in the overall economy. Any other objective is likely to result in the suboptimal allocation of funds and therefore lead to less than optimal capital formation and growth in the economy. This is not to say that management should ignore social responsibility, such as protecting consumers, paying fair wages, maintaining fair hiring practices and safe working conditions, supporting education, and becoming actively involved in environmental issues like clean air and water. Stakeholders other than stockholders no longer can be ignored. These stakeholders include creditors, employees, cus tomers, suppliers, communities in which a company operates, and others. The impact of decisions on them must be recognized. Many people feel that a com. pany has no choice but to act in socially responsible ways; they argue that share- holder wealth and, perhaps, the corporation's very existence depend on its being socially responsible. Because criteria for social responsibility are not clearly defined, however, it is difficult to formulate a consistent objective. When society, acting through Congress and other representative bodies, establishes the rules governing the trade-off between social goals and economic efficiency, the task for the corporation is clearer. The company can be viewed as producing both private and social goods, and the maximization of shareholder wealth remains a viable corporate objective. The functions of finance involve three major decisions a company must make: the investment decision, the financing decision, and the dividend decisionChapter 1 2 Goals and Functions of Finance Each must be considered in relation to our objective; an optimal combination of the three will create value Investment Decision ‘The investment decision is the most important of the three decisions when it ccomes to the creation of value. Capital investment is the allocation of capital to investment proposals whose benefits are to be realized in the future. Because the future benefits are not known with certainty, investment proposals necessarily inyolve tisk. Consequently, they should be evaluated in relation to their expected return and risk, for these are the factors that affect the firm’ valuation in the mar ketplace. Included also under the investment decision is the decision to reallocate capital when an asset no longer economically justifies the capital committed to it. The investment decision, then, determines the total amount of assets held by the firm, the composition of these assets, and the business-risk complexion of the firm as perceived by suppliers of capital. The theoretical portion of this decision is taken up in Part 2. Using an appropriate acceptance criterion, o required rate of retum, is fundamental to the investment decision, Because of the paramount and integrative importance of this issue, we shall pay considerable attention to deter- ‘mining the appropriate required rate of return for an investment project, for a divi- sion of a company, for the company as a whole, and for a prospective acquisition In addition to selecting new investments, a firm must manage existing assets efficiently. Financial managers have varying degrees of operating responsibility for existing assets, they are more concerned with the management of current assets than with fixed assets. In Part 4, we shall explore ways in which to manage current assets efficiently in order to maximize profitability relative to the amount of funds tied up in an asset. Determining a proper level of liquidity is very much a part of this management, and its determination should be in keeping with the firms over- all valuation. Although financial managers have litle or no operating responsibility for fixed assets and inventories, they are instrumental in allocating capital to these assets by virtue of their involvement in capital investment, In Parts 2 and 6, we consider mergers and acquisitions from the standpoint of an investment decision. These external investment opportunities can be evaluated in the same general manner as an investment proposal that is generated internally, ‘The market for corporate control is ever present in this regard, and this topic is taken up in Part 6, Growth in a company can be internal, external, or both, domestic, and international; therefore, Part 6 also considers growth through inter- national operations. With the globalization of finance in recent years, this book places substantial emphasis on international aspects of financial decision making. Financing Decision In the second major decision of the firm, the financing decision, the financial manager is concerned with determining the best financing mix or capital struc- ture. If a company can change its total valuation by varying its capital structure, an optimal financing mix would exist, in which market price per share could be 56 Part.1 29 Foundations of Finance maximized. In Chapters 9 and 10 of Part 3, we take up the financing decision in relation to the overall valuation.of:the firm. Our concern is with exploring the implications of variation in capital structure on the valuation of the firm. In Chapters 15 and 16, we examine short- and intermediate-term financing, This is followed in Part 5 with an investigation of the various methods of long-term financing. The emphasis is on not only certain valuation underpinnings but also the managerial aspects of financing, as we analyze the features, concepts, and problems associated with alternative methods Part 5 also investigates the interface of the firm with the capital markets, the ever-changing environment in which financing decisions are made, and how a company can manage its financial risk through various hedging devices, In Part 6, corporate and distress restructuring are explored. While aspects of restructuring fall across all three major decisions of the firm, this topic invariably involves financing, either new sources or a rearrangement of existing sources. Dividend Decision The third important decision of the firm is its dividend policy, which is examined in Chapter 11. The dividend decision includes the percentage of earnings paid to stockholders in cash dividends, the stability of absolute dividends about a trend, stock dividends and splits, and the repurchase of stock. The cividend-payout ratio determines the amount of earnings retained in the firm and must be evaluated in the light of the objective of maximizing shareholder wealth. The value, if any, of a dividend to investors must be balanced against the opportunity cost of the retained earnings lost as a means of equity financing. Thus, we see that the divi- dend decision should be analyzed in relation to the financing de‘ Financial Management Financial management involves the solution of the three major decisions. Together, they-determine the value of a company to its shareholders. Assuming that our objective is to maximize this value, the firm should strive for an optimal combination of the three interrelated decisions, solved jointly. The decision to invest in a new capital project, for example, necessitates finarcing the investment. ‘The financing decision, in turn, influences and is influenced by the dividend deci- sion, for retained earnings used in internal financing represent dividends forgone by stockholders. With a proper conceptual framework, join: decisions that tend to be optimal can be reached. The main thing is that the financial manager relate each decision to its effect on the valuation of the firm Because valuation concepts are basic to understanding financial manage- 3 ment, these concepts are investigated in depth in Chapters 2 through 5. Thus, the first five chapters serve as the foundation for the subsequent development of | BERNs; the book. They introduce key concepts: the time value of money, market effi- Cone ciency, risk-retuimn trade-offs, valuation in a market portfolio context, and the F valuation of relative financial claims using option pricing theory. These concepts Dona will be applied in the remainder of the book.Chapter 1 29 Goals and Functions of Finance 7 In an endeavor to make optimal decisions, the financial manager makes use of certain analytical tools in the analysis, planning, and control activities of the firm. Financial analysis is a necessary condition, or prerequisite, for making sound financial decisions, we examine the tools of analysis in Part 7. One of the important roles of a chief financial officer is to provide accurate information on financial performance. This material appears at the end of the book in order to set it apart from the book's sequence of development. Depending on the reader's background, it can be taken up early or used for reference purposes throughout. > Questions 1, Why should a company concentrate primarily on wealth maximization instead of profit maximization? 2. “Abasic rationale for the objective of maximizing the wealth position of the stockholder as a primary business goal is that such an objective may reflect the most efficient use of society's economic resources and thus lead to a max- mization of society’ economic wealth.” Briefly evaluate this observation, 3. Beta-Max Corporation is considering two investment proposals. One involves the development of 10 discount record stores in Chicago. Each store is expected to provide an annual after-tax profit of $35,000 for 8 years, alter which the lease will expire and the store will terminate. The other pro: posal involves a classical record of the month club. Here, the company will devote much effort to teaching the public to appreciate classical music. Management estimates that after-tax profits will be zero for 2 years, after which they will grow by $40,000 a year through year 10 and remain level thereafter. The life of the second project is 15 years. On the basis of this information, which project do you prefer? Why? 4, What are the major functions of the financial manager? What do these func- tions have in common? 5. Should the managers of a company own sizable amounts of stock in the company? What are the pros and cons? 6. Inrecent years, there have been a number of environmental, pollution, hir- ing, and other regulations imposed on businesses. In view of these changes, is maximization of sharcholder wealth still a realistic objective? 7. Asan investor, do you believe that some managers are paid too much? Do not their rewards come at your expense? 8. How does the notion of risk and reward govern the behavior of financial managers? 5) Selected References BERNSTEIN, PerER L., Capital Ideas. New York: Free Press, 1992, CORNELL, BRADFORD, and ALAN C. SHAPIRO, "Corporate Stakeholders and Corporate Finance," Financial Managenent, 16 (Spring 1987), 514. DONALDSON, GORDON, "Financial Goals: Management vs. Stockholders,” Haroard Business Revieo, 41 (May-June 1963), 116-29,