Holland John - Five-Minute MBA, Corporate Finance.pdf

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An Overview of Corporate
Finance and the Financial
Environment
1
1
See http://www.fortune.
com for updates on the U.S.
ranking. Fortune also ranks
the Global Most Admired.
I n a beauty contest for companies, the winner is . . . General Electric.
Or at least General Electric is the most admired company in America, according
to Fortune magazine’s annual survey. The other top ten finalists are Cisco Systems, Wal-
Mart Stores, Southwest Airlines, Microsoft, Home Depot, Berkshire Hathaway, Charles
Schwab, Intel, and Dell Computer. What do these companies have that separates them
from the rest of the pack?
According to more than 4,000 executives, directors, and security analysts, these
companies have the highest average scores across eight attributes: (1) innovativeness,
(2) quality of management, (3) employee talent, (4) quality of products and services,
(5) long-term investment value, (6) financial soundness, (7) social responsibility, and (8)
use of corporate assets.
These companies also have an incredible focus on using technology to reduce
costs, to reduce inventory, and to speed up product delivery. For example, workers at
Dell previously touched a computer 130 times during the assembly process but now
touchitonly60times.Usingpoint-of-saledata,Wal-Martisabletoidentifyandmeetsur-
prising customer needs, such as bagels in Mexico, smoke detectors in Brazil, and house
paint during the winter in Puerto Rico. Many of these companies are changing the way
business works by using the Net, and that change is occurring at a break-neck pace. For
example,in1999GE’splasticsdistributionbusinessdidlessthan$2,000perdayofbusi-
nessonline.A year later the divisiondidmorethan$2,000,000perdayine-commerce.
Many companies have a difficult time attracting employees. Not so for the most
admiredcompanies,whichaverage26applicantsforeachjobopening.Thisisbecause,
in addition to their acumen with technology and customers, they are also on the leading
edge when it comes to training employees and providing a workplace in which people
canthrive.
In a nutshell, these companies reduce costs by having innovative production
processes, they create value for customers by providing high-quality products and
services, and they create value for employees through training and fostering an envi-
ronment that allows employees to utilize all of their skills and talents.
Do investors benefit from this focus on processes, customers, and employees?
During the most recent five-year period, these ten companies posted an average an-
nual stock return of 41.4 percent, more than double the S&P 500’s average annual re-
turn of 18.3 percent. These exceptional returns are due to the ability of these com-
panies to generate cash flow. But, as you will see throughout this book, a company
can generate cash flow only if it also creates value for its customers, employees, and
suppliers.
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An Overview of Corporate Finance and the Financial Environment
4
CHAPTER 1 An Overview of Corporate Finance and the Financial Environment
T his chapter should give you an idea of what corporate finance is all about, includ-
ing an overview of the financial markets in which corporations operate. But before
getting into the details of finance, it’s important to look at the big picture. You’re
probably back in school because you want an interesting, challenging, and rewarding
career. To see where finance fits in, let’s start with a five-minute MBA.
The Five-Minute MBA
Okay, we realize you can’t get an MBA in five minutes. But just as an artist quickly
sketches the outline of a picture before filling in the details, we can sketch the key el-
ements of an MBA education. In a nutshell, the objective of an MBA is to provide
managers with the knowledge and skills they need to run successful companies, so we
start our sketch with some common characteristics of successful companies. In partic-
ular, all successful companies are able to accomplish two goals.
Visit http://ehrhardt.
swcollege.com to see the
web site accompanying this
text. This ever-evolving site,
for students and instructors,
is a tool for teaching, learn-
ing, financial research, and
job searches.
1. All successful companies identify, create, and deliver products or services that are
highly valued by customers, so highly valued that customers choose to purchase
them from the company rather than from its competitors. This happens only if the
company provides more value than its competitors, either in the form of lower
prices or better products.
2. All successful companies sell their products/services at prices that are high enough
to cover costs and to compensate owners and creditors for their exposure to risk. In
other words, it’s not enough just to win market share and to show a profit. The
profit must be high enough to adequately compensate investors.
It’s easy to talk about satisfying customers and investors, but it’s not so easy to ac-
complish these goals. If it were, then all companies would be successful and you
wouldn’t need an MBA! Still, companies such as the ones on Fortune ’s Most Admired
list are able to satisfy customers and investors. These companies all share the follow-
ing three key attributes.
The Key Attributes Required for Success
First, successful companies have skilled people at all levels inside the company, includ-
ing (1) leaders who develop and articulate sound strategic visions; (2) managers who
make value-adding decisions, design efficient business processes, and train and moti-
vate work forces; and (3) a capable work force willing to implement the company’s
strategies and tactics.
Second, successful companies have strong relationships with groups that are out-
side the company. For example, successful companies develop win-win relationships
with suppliers, who deliver high-quality materials on time and at a reasonable cost. A
related trend is the rapid growth in relationships with third-party outsourcers, who
provide high-quality services and products at a relatively low cost. This is particularly
true in the areas of information technology and logistics. Successful companies also
develop strong relationships with their customers, leading to repeat sales, higher
profit margins, and lower customer acquisition costs.
Third, successful companies have sufficient capital to execute their plans and sup-
port their operations. For example, most growing companies must purchase land,
buildings, equipment, and materials. To make these purchases, companies can reinvest
a portion of their earnings, but most must also raise additional funds externally, by
some combination of selling stock or borrowing from banks and other creditors.
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An Overview of Corporate Finance and the Financial Environment
3
How Are Companies Organized?
5
Just as a stool needs all three legs to stand, a successful company must have all
three attributes: skilled people, strong external relationships, and sufficient capital.
Consult http://www.
careers-in-finance.com for
an excellent site containing
information on a variety of
business career areas, list-
ings of current jobs, and
other reference materials.
The MBA, Finance, and Your Career
Tobesuccessful,acompanymustmeetitsfirstgoal—theidentification,creation,and
deliveryofhighlyvaluedproductsandservices.Thisrequiresthatitpossessall three
ofthekeyattributes.Therefore,it’snotsurprisingthatmostofyourMBAcoursesare
directly related to these attributes. For example, courses in economics, communica-
tion,strategy,organizationalbehavior,andhumanresourcesshouldprepareyoufora
leadership role and enable you to effectively manage your company’s work force.
Othercourses,suchasmarketing,operationsmanagement,andinformationtechnol-
ogy are designed to develop your knowledge of specific disciplines, enabling you to
develop the efficient business processes and strong external relationships your com-
pany needs. Portions of this corporate finance course will address raising the capital
yourcompanyneedstoimplementitsplans.Inparticular,thefinancecoursewillen-
able you to forecast your company’s funding requirements and then describe strate-
giesforacquiringthenecessarycapital.Inshort,yourMBAcourseswill giveyouthe
skillstohelpacompanyachieveitsfirstgoal—producinggoodsandservicesthatcus-
tomerswant.
Recall, though, that it’s not enough just to have highly valued products and satis-
fied customers. Successful companies must also meet their second goal, which is to
generate enough cash to compensate the investors who provided the necessary capital.
To help your company accomplish this second goal, you must be able to evaluate any
proposal, whether it relates to marketing, production, strategy, or any other area, and
implement only the projects that add value for your investors. For this, you must have
expertise in finance, no matter what your major is. Thus, corporate finance is a critical
part of an MBA education and will help you throughout your career.
What are the goals of successful companies?
What are the three key attributes common to all successful companies?
How does expertise in corporate finance help a company become successful?
How Are Companies Organized?
There are three main forms of business organization: (1) sole proprietorships, (2)
partnerships, and (3) corporations. In terms of numbers, about 80 percent of busi-
nesses are operated as sole proprietorships, while most of the remainder are divided
equally between partnerships and corporations. Based on dollar value of sales, how-
ever,about80percentofallbusinessisconductedbycorporations,about13percent
by sole proprietorships, and about 7 percent by partnerships and hybrids. Because
most business is conducted by corporations, we will concentrate on them in this
book. However, it is important to understand the differences among the various
forms.
Sole Proprietorship
A sole proprietorship is an unincorporated business owned by one individual. Going
into business as a sole proprietor is easy—one merely begins business operations.
However, even the smallest business normally must be licensed by a governmental
unit.
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An Overview of Corporate Finance and the Financial Environment
6
CHAPTER 1 An Overview of Corporate Finance and the Financial Environment
The proprietorship has three important advantages: (1) It is easily and inexpen-
sively formed, (2) it is subject to few government regulations, and (3) the business
avoids corporate income taxes.
The proprietorship also has three important limitations: (1) It is difficult for a
proprietorship to obtain large sums of capital; (2) the proprietor has unlimited per-
sonal liability for the business’s debts, which can result in losses that exceed the
moneyheorsheinvestedinthecompany;and(3)thelifeofabusinessorganizedasa
proprietorship is limited to the life of the individual who created it. For these three
reasons,soleproprietorshipsareusedprimarilyforsmall-businessoperations.How-
ever, businesses are frequently started as proprietorships and then converted to cor-
porations when their growth causes the disadvantages of being a proprietorship to
outweightheadvantages.
Partnership
A partnership exists whenever two or more persons associate to conduct a non-
corporate business. Partnerships may operate under different degrees of formality,
ranging from informal, oral understandings to formal agreements filed with the secre-
tary of the state in which the partnership was formed. The major advantage of a part-
nership is its low cost and ease of formation. The disadvantages are similar to those as-
sociated with proprietorships: (1) unlimited liability, (2) limited life of the
organization, (3) difficulty transferring ownership, and (4) difficulty raising large
amounts of capital. The tax treatment of a partnership is similar to that for propri-
etorships, but this is often an advantage, as we demonstrate in Chapter 9.
Regarding liability, the partners can potentially lose all of their personal assets,
even assets not invested in the business, because under partnership law, each partner is
liable for the business’s debts. Therefore, if any partner is unable to meet his or her
pro rata liability in the event the partnership goes bankrupt, the remaining partners
must make good on the unsatisfied claims, drawing on their personal assets to the ex-
tent necessary. Today (2002), the partners of the national accounting firm Arthur
Andersen, a huge partnership facing lawsuits filed by investors who relied on faulty
Enron audit statements, are learning all about the perils of doing business as a
partnership. Thus, a Texas partner who audits a business that goes under can bring
ruin to a millionaire New York partner who never went near the client company.
The first three disadvantages—unlimited liability, impermanence of the organiza-
tion, and difficulty of transferring ownership—lead to the fourth, the difficulty partner-
ships have in attracting substantial amounts of capital. This is generally not a problem
for a slow-growing business, but if a business’s products or services really catch on, and
if it needs to raise large sums of money to capitalize on its opportunities, the difficulty in
attracting capital becomes a real drawback. Thus, growth companies such as Hewlett-
Packard and Microsoft generally begin life as a proprietorship or partnership, but at
some point their founders find it necessary to convert to a corporation.
Corporation
A corporation is a legal entity created by a state, and it is separate and distinct from
its owners and managers. This separateness gives the corporation three major advan-
tages: (1) Unlimited life. A corporation can continue after its original owners and man-
agers are deceased. (2) Easy transferability of ownership interest. Ownership interests can
be divided into shares of stock, which, in turn, can be transferred far more easily than
can proprietorship or partnership interests. (3) Limited liability. Losses are limited to
the actual funds invested. To illustrate limited liability, suppose you invested $10,000
in a partnership that then went bankrupt owing $1 million. Because the owners are
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