A Reader's Guide

This is a book about corporate finance, but every decision that a firm makes has a corporate finance component to it, even if it is called a strategic, a marketing or an advertising decision. Moreover, the principles of corporate finance apply not just to corporations and large businesses. Every business, small or large, privately owned or publicly traded, has to make decisions about how to raise funds for investments, and where to invest these funds. The first theme that I hope will come through in this book is the universality of the basic principles of corporate finance.

The second theme of this book is that corporate financial theory has its grounding in applications. I have adopted a very simple rule in pulling together material for this book. If I cannot apply it to real companies with real data, I have taken the material out of the book.

There is a third theme that is more difficult to explain. You might start off with the notion that corporate finance is an exercise in number crunching, with little room for creative thinking or bold strokes of imagination. I hope to show that while numbers are central to corporate finance, there is a great deal of room for innovation and creative solutions.

Structure of the Book

The book is structured around the three principles that comprise corporate finance. The first section lays the groundwork for the analysis of these principles. It begins with a discussion of the objective of stock price maximization, which underlies corporate financial theory, and follows this up with an examination of three basic tools that we use in decision making - the concept of present value, the analysis of financial statements and the valuation of any asset. The next section covers the decision of whether and where to invest a firm’s resources (the investment decision). The section following covers the funding decision and analyzes what the funding options for a firm are, and what the best options may be (the financing decision). The decisions about how much to reinvest back into the business — the dividend decision - and how much to take out of it are covered in the next section. The final section returns to look at the link between valuation and corporate finance decisions.

A Real World Focus

The proliferation of news and information about corporations making decisions every day suggests that we do not need to use hypothetical businesses to illustrate the principles of corporate finance. I will use three firms through this book to make my points about corporate financial policy:

  1. Boeing is the leading manufacturer of commercial jet aircraft in the world and provides related services to the commercial airline industry worldwide. The company also has extensive interests in information, space and defense systems, including military aircraft, helicopters, space and missile systems. We will use it to illustrate the issues that a large manufacturing firm, with a diversified stockholder base, has to face in the course of making investment, financing and dividend decisions.
  2. The Home Depot operates more than 600 stores in the United States and Canada, selling home improvement products such as plumbing, heating and electrical supplies, floor and wall coverings, hardware, tools and paint. We will use the Home Depot to examine some of the questions that come up for service firms, which make small investments that are generally not capital-intensive, in corporate finance.
  3. Infosoft is a privately owned firm which develops and sells entertainment software. We will take Infosoft through the corporate financial decision making process to illustrate some of the issues that come up when we look at private businesses with limited information, and we will examine how high growth businesses in uncertain environments make decisions.

Many of the chapters are followed by an In-Practice section where you can apply the same principles to any firm that you choose to analyze.

An Interactive Learning Tool

In order to make the learning in this book as interactive and current as possible, I will employ a variety of devices:

A Chapter-by-Chapter Guide

Chapter 1 is a short chapter that lays out what I think corporate finance is all about and provides a sense of why I have structured the book the way I have. For those without a finance background, it provides a measure of how I view a business and its functions.

Chapter 2 is the philosophical core of this book. The objective in corporate finance is the maximization of firm value, but this objective is not universally accepted. In fact, there are many both within and outside the business community who argue that it is either too narrow an objective or the wrong objective. I spend the first half of this chapter examining many of the real limitations these critics point to, but then I present what I hope is a strong case that firms should continue to focus on this objective.

A significant portion of what we do in finance relates to the time value of money. We consider the mechanics of time value in chapter 3, but in the larger context of not only decisions that firms might have to make on a day-to-day basis as well as decisions that individuals make on how much to save for retirement or a child’s college education.

In chapter 4, on financial statements, I tried to maintain a balance between accounting mechanics and the imperatives of financial analysis. I wanted the chapter to include enough on how financial statements are constructed to allow you to use it as a reference guide when looking at a company’s annual report or 10-K. At the same time, I wanted to present the questions that we as financial analysts would like these statements to answer, and the modifications that need to be made to get the answers.

Chapter 5 provides an introduction to valuing all kinds of assets, from default-free zero coupon bonds to equity in high growth companies. I have also used chapter 5 as my way of introducing the notion of price as distinct from value. I use this setting to describe the notion of market efficiency and why it is so central to corporate finance.

The next 10 chapters cover the investment decision. I would like explain both their organization and their sequence. First, I do not believe that it makes much sense to talk about investment decision rules, before explaining what projects need to make as hurdle rates. Consequently, I deal with risk and expected returns in the chapters 6 through 8. I also draw a clear distinction between measuring hurdle rates for a firm in chapter 7, and for individual projects in chapter 8, because I believe this distinction is particularly important for firms in multiple lines of business. Second, I do spend a substantial amount of time on the estimation issues associated with applying risk and return models in practice. This reflects my belief that the biggest challenges with estimating hurdle rates are not theoretical but are related to estimation issues. Third, I consider investments in foreign projects (in chapter 11), investments in working capital (in chapter 13 and 14) and investments in existing projects (chapter 15) within the broader context of investment analysis. I have tried to bring to the analysis of these investment decisions the same objectives and analytical tools that I would use on any investment. Fourth, I have tried to consider ways in which project interactions, synergies and options can be incorporated into the investment analysis in chapter 12.

I next turn to the financing decision. I begin by presenting the entire range of financing choices available to firms in chapter 16, ranging from private equity to preferred stock. While I considered looking at these choices in separate chapter, I thought it was more important that I present the choices in one chapter, and emphasize both the common elements and the differences between them. In chapter 17, I look at two related questions. The first is how a firm’s financing choices vary as it goes through its life cycle of growth, expansion, maturity and decline. The second is the process by which firms make the transitions from one stage of financing (owner’s funds, private equity) to another. In chapters 18 through 20, I consider three steps in the analysis of a firm’s financing mix, beginning with an analysis of the optimal financing mix for a firm (chapter 18 and 19), followed by an examination of what to do when a firm is under or over levered, and how to determine the right kind of financing a firm should use (chapter 20). Again, the emphasis is on applying the theory, with reasonable assumptions, to help firms make their financing decisions.

In chapters 21 through 23, I look at the dividend decision. I begin, in chapter 21, with a fairly conventional treatment of dividends, and the trade off on dividend payout, as well as the different hypotheses about whether dividends increase or decrease value. In chapter 22, I look at how much a firm can pay in dividends by measuring the cash left over after all reinvestment needs have been met, and whether there will be pressure on a firm to pay this out. Finally, in chapter 23, I expand the dividend decision to look at other ways in which firms can affect the value of the stock held by their owners, ranging from the cosmetic (stock splits and tracking stock) to divestitures and spin offs.

I return to valuation in chapters 24 through 26. Having laid the corporate financial groundwork, I can now link valuation to the investment, financing and dividend decisions of a firm. I do this, in the context of valuing a firm in chapter 24, and to examine how to increase the value of a firm in chapter 25. Finally, in chapter 26, I apply the same valuation tools to value control and synergy in acquisitions.

Chapter 27 represents my attempt to apply option pricing models in a variety of contexts in corporate finance and valuation. I begin by applying it to value the options embedded in investment projects, including the options to expand, abandon or delay projects. I also use it to value financing flexibility and value equity in deeply troubled firms. While you might think that I have over reached in some of these applications, I feel that we should be doing more than just talking about these options.

As you read this book, I hope you find material that is interesting and useful to you, but more importantly, I hope you also find as much enjoyment as I have in the creative components that go into corporate financial analysis. Have fun!!!