The Role of the Financial Manager
To carry on business, companies need an almost endless variety of real assets. Many of
these assets are tangible, such as machinery, factories, and offices; others are intangible,
such as technical expertise, trademarks, and patents. All of them must be paid for.
To obtain the necessary money, the company sells financial assets, or securities.3
These pieces of paper have value because they are claims on the firm’s real assets and
the cash that those assets will produce. For example, if the company borrows money
from the bank, the bank has a financial asset. That financial asset gives it a claim to a
Sole
Proprietorship Partnership Corporation
Who owns the business?
Are managers and owner(s)
separate?
What is the owner’s
liability?
Are the owner and business
taxed separately?
TABLE 1.1
Characteristics of
business organizations
3 For present purposes we are using financial assets and securities interchangeably, though “securities” usually
refers to financial assets that are widely held, like the shares of IBM. An IOU (“I owe you”) from your
brother-in-law, which you might have trouble selling outside the family, is also a financial asset, but most people
would not think of it as a security.
REAL ASSETS Assets
used to produce goods and
services.
FINANCIAL ASSETS
Claims to the income
generated by real assets.
Also called securities.
The manager Partners Shareholders
No No Usually
Unlimited Unlimited Limited
No No Yes
8 SECTION ONE
stream of interest payments and to repayment of the loan. The company’s real assets
need to produce enough cash to satisfy these claims.
Financial managers stand between the firm’s real assets and the financial markets
in which the firm raises cash. The financial manager’s role is shown in Figure 1.1,
which traces how money flows from investors to the firm and back to investors again.
The flow starts when financial assets are sold to raise cash (arrow 1 in the figure). The
cash is employed to purchase the real assets used in the firm’s operations (arrow 2).
Later, if the firm does well, the real assets generate enough cash inflow to more than
repay the initial investment (arrow 3). Finally, the cash is either reinvested (arrow 4a)
or returned to the investors who contributed the money in the first place (arrow 4b). Of
course the choice between arrows 4a and 4b is not a completely free one. For example,
if a bank lends the firm money at stage 1, the bank has to be repaid this money plus interest
at stage 4b.
This flow chart suggests that the financial manager faces two basic problems. First,
how much money should the firm invest, and what specific assets should the firm invest
in? This is the firm’s investment, or capital budgeting, decision. Second, how
should the cash required for an investment be raised? This is the financing decision.
THE CAPITAL BUDGETING DECISION
Capital budgeting decisions are central to the company’s success or failure. For example,
in the late 1980s, the Walt Disney Company committed to construction of a Disneyland
Paris theme park at a total cost of well over $2 billion. The park, which opened
in 1992, turned out to be a financial bust, and Euro Disney had to reorganize in May
1994. Instead of providing profits on the investment, accumulated losses on the park by
that date were more than $200 million.
Contrast that with Boeing’s decision to “bet the company” by developing the 757 and
767 jets. Boeing’s investment in these planes was $3 billion, more than double the total
value of stockholders’ investment as shown in the company’s accounts at the time. By
1997, estimated cumulative profits from this investment were approaching $8 billion,
and the planes were still selling well.
Disney’s decision to invest in Euro Disney and Boeing’s decision to invest in a new
generation of airliners are both examples of capital budgeting decisions. The success of
such decisions is usually judged in terms of value. Good investment projects are worth
more than they cost. Adopting such projects increases the value of the firm and therefore
the wealth of its shareholders. For example, Boeing’s investment produced a stream
of cash flows that were worth much more than its $3 billion outlay.
Not all investments are in physical plant and equipment. For example, Gillette spent
around $300 million to market its new Mach3 razor. This represents an investment in a
(2)
(3)
(1)
(4b)
Financial manager (4a)
Firm’s
operations
(a bundle
of real assets)
Financial
markets
(investors holding
financial assets)
FIGURE 1.1
Flow of cash between capital
markets and the firm’s
operations. Key: (1) Cash
raised by selling financial
assets to investors; (2) cash
invested in the firm’s
operations; (3) cash
generated by the firm’s
operations; (4a) cash
reinvested; (4b) cash
returned to investors.
FINANCIAL MARKETS
Markets in which financial
assets are traded.
CAPITAL BUDGETING
DECISION Decision as
to which real assets the firm
should acquire.
FINANCING DECISION
Decision as to how to raise
the money to pay for
investments in real assets.
The Firm and the Financial Manager 9
nontangible asset—brand recognition and acceptance. Moreover, traditional manufacturing
firms are not the only ones that make important capital budgeting decisions. For
example, Intel’s research and development expenditures in 1998 were more than $2.5
billion.4 This investment in future products and product improvement will be crucial to
the company’s ability to retain its existing customers and attract new ones.
Today’s investments provide benefits in the future. Thus the financial manager is
concerned not solely with the size of the benefits but also with how long the firm must
wait for them. The sooner the profits come in, the better. In addition, these benefits are
rarely certain; a new project may be a great success—but then again it could be a dismal
failure. The financial manager needs a way to place a value on these uncertain future
benefits.
We will spend considerable time in later material on project evaluation. While no one
can guarantee that you will avoid disasters like Euro Disney or that you will be blessed
with successes like the 757 and 767, a disciplined, analytical approach to project proposals
will weight the odds in your favor.
THE FINANCING DECISION
The financial manager’s second responsibility is to raise the money to pay for the investment
in real assets. This is the financing decision. When a company needs financing,
it can invite investors to put up cash in return for a share of profits or it can promise
investors a series of fixed payments. In the first case, the investor receives newly
issued shares of stock and becomes a shareholder, a part-owner of the firm. In the second,
the investor becomes a lender who must one day be repaid. The choice of the longterm
financing mix is often called the capital structure decision, since capital refers
to the firm’s sources of long-term financing, and the markets for long-term financing
are called capital markets.5
Within the basic distinction—issuing new shares of stock versus borrowing money
—there are endless variations. Suppose the company decides to borrow. Should it go to
capital markets for long-term debt financing or should it borrow from a bank? Should
it borrow in Paris, receiving and promising to repay euros, or should it borrow dollars
in New York? Should it demand the right to pay off the debt early if future interest rates
fall?
The decision to invest in a new factory or to issue new shares of stock has long-term
consequences. But the financial manager is also involved in some important short-term
decisions. For example, she needs to make sure that the company has enough cash on
hand to pay next week’s bills and that any spare cash is put to work to earn interest. Such
short-term financial decisions involve both investment (how to invest spare cash) and
financing (how to raise cash to meet a short-term need).
Businesses are inherently risky, but the financial manager needs to ensure that risks
are managed. For example, the manager will want to be certain that the firm cannot be
wiped out by a sudden rise in oil prices or a fall in the value of the dollar. We will look
at the techniques that managers use to explore the future and some of the ways that the
firm can be protected against nasty surprises.