Financial Management Principle 1

Financial Management is the practice of how companies acquire money, known as the
financing decision, and how they use money, known as the investment decision.

Financial management focuses primarily on the firm’s long-term financing and investment
decisions, where long-term refers to at least one year. The long-term financing it receives comes
from creditors who lend for more than one year and, of course, from the owners, also known as
the stockholders. The stockholders’ investment is often called equity. The stockholders can, of
course, sell their stock to others, but the shares themselves have an infinite life. The study of
how companies decide on how much capital to acquire, how much of it should be debt and how
much of it should be equity, and how much should be returned to shareholders in the form of
dividends or repurchases of shares is called the financing decision.

Financial managers acquire this money and put it to work investing in the assets of the firm. The
decision to invest in assets is called, appropriately, the investment decision.

The money acquired and invested is often called capital. Put simply, these funds are just the
firm’s financial resources or, its money.

Financial Management Principle 2

Companies exist because of their shareholders, and they should be managed for their
shareholders, not other groups.

Shareholders are the owners of companies. They invest their money with the expectation of
receiving a return. For a company that has no debt, their investment is exposed to some risk,
which is determined strictly from the risk of the assets. If the assets generate insufficient cash
flows, the shareholders will be disappointed, but without debt, bankruptcy is not possible. If the
company borrows, the shareholders assume some additional risk because the creditors have first
claim on the cash flows and assets. Because of these risks, the shareholders expect a return that
makes them willing to take the risk.

The company should act in such a manner that it places the shareholders first. Otherwise, the
shareholders will either not want to invest in the company or would be willing to pay less for a
share of stock. Some companies, particularly in certain other countries, place a high priority on
the needs of stakeholders, such as employees, suppliers, government, etc. These constituencies
could be important but they are secondary to the shareholders. Without shareholders, there are
no companies. Companies that place their shareholders on an equal or inferior level to
stakeholders will have a harder time performing to the greatest potential. When companies
perform at their greatest potential, they generate jobs, opportunities for suppliers, and pay high
taxes, thereby meeting the needs of many of these stakeholder groups.
 Financial Management Principle 3
When the board of directors and/or management do not act in the best interests of the
shareholders, the firm incurs agency costs, which are borne by the shareholders in the form
of a lower stock price.
The shareholders are represented by an elected board of directors, which in turn hires
management to operate the company. The board should always put the shareholders first and try
to get management to act in the best interests of the shareholders and not the best interests of
management or the board. In some companies, however, the board and management fail to act in
the shareholders’ best interests, and the shareholders bear these agency costs, which keeps the
price of the stock lower than what it otherwise would be. Nearly all companies have some
agency costs, but some have much more than others.

The relationship between the shareholders, the board of directors, and management is
called corporate governance. When boards properly represent shareholders, a company is said
to have good corporate governance.

Financial Management Principle 4

The objective of the firm should be to maximize shareholder wealth.

Shareholder wealth is the price of the stock times the number of shares. Companies cannot
maximize shareholder wealth by adjusting the number of shares, so maximizing shareholder
wealth is the same as maximizing the share price.

Many people think the objective is to make the most profit or earnings per share, but this is not
true. Profit is a short-term figure from the recent past. Profit also does not measure actual cash.
A company cannot spend profits or pay dividends with just profits. It must have cash. For
example, sales contribute to profits but some sales are not collected until years later and some
never are. Expenses incurred are often not paid until later. Profit is also a figure that can be
distorted by different accounting policies. Two accountants can legitimately record a transaction
in two different ways.

Profit is only a noisy signal of how a company has recently performed. Profits do matter to
government, however, because taxes are based on profits. Because a company should want to
pay the lowest taxes possible, a good objective would actually be to minimize profits. As a
practical reality, however, that would probably not work. Profits are somewhat correlated with
cash flows, so firms would not want to take actions that would lower profits if these actions
would also lower cash flows.

Since shareholder wealth reflects the value of the assets less the value of the debt, we can also
say that the objective is equivalent to maximizing the value of the firm. Creditors can benefit by
no more than what has been promised to them. Hence, making the assets as large as possible in
value is equivalent to maximizing the value of the firm and shareholder wealth.
Thus, the stock price reflects the value of all future cash flows of the firm. Maximizing the stock
price, shareholder wealth, and the value of the firm are all equivalent objectives. The entire
purpose of financial management is, put simply, to create value - to turn money into more money
– for the shareholders.

Financial Management Principle 5

A dollar received or paid at one point in time is not worth the same as a dollar received or
paid at another point in time.

This concept is called the time value of money. It is based on the simple idea that through the
power of interest, money at one point in time grows to more money at another point in time. Just
as a bank pays interest on CDs and savings accounts, any amount of money at a particular date is
worth less than the same amount of money at a later date because the money at the earlier date
would earn interest and be worth more at the later date.

The accumulation of interest over time is called compounding or compound interest. Money at
one point in time is converted to its value at a later point in time by a term called the compound
interest factor.

The opposite of compounding is discounting, which is a far more important concept in finance.
From the above statements about compounding, money at a future date is worth less today. This
future sum of money is converted to its current value, called the present value, by a term called
the present value factor. Since valuation of stocks, bonds, and assets is such an important
concept in finance, we often find ourselves determining the present value of something.
Financial Management Principle 6

The value of a stock or bond is the present value of the future cash flows that the stock or
bond is expected to pay to its owners.

Stocks and bonds are the primary sources of capital of a firm. Stockholders and bondholders
invest in the firm because they expect to earn a return that compensates them for the risk they
take. It is important to be able to determine the values of stocks and bonds.

By issuing bonds, companies are borrowing money, promising to return it in the form of interest
and principal. The interest and principal payments are known so finding their value is just a
matter of finding their present value. The discount rate is often called the bond’s yield-to-
maturity or just yield, and represents the return the bondholders expect and require in order to
justify lending the money. Of course, companies can default on their bonds, and bondholders
expect higher returns to compensate them for this risk. At this point in the study of finance, the
possibility of default is not being considered.

Stocks are more complex because their payments are not assured. To find the value of a stock,
we must estimate the cash flows that are expected to be paid by the company to the stockholders
in the future. These cash flows occur in the form of dividends. So we find the value of a stock
by discounting the expected future dividends. Because a stock has an infinite life, we must
discount the expected future dividends all the way to infinity.

Of course, as a practical matter it is impossible to forecast the dividends to infinity. We typically

avoid this problem by making assumptions about projected growth rates of dividends. Stocks
usually grow in stages, with early rapid growth eventually tailing off to a declining rate of
growth, whereupon dividends might be expected to grow at a small but constant rate forever or
might even remain level forever. When dividend growth can be projected at a constant rate, even
if that rate is zero, formulas for present value calculations are simple.

As with bonds, the discount rate is the return investors expect and require. Thus, it is called the
required rate of return or expected rate of return, or just the required rate or expected rate. It is
also occasionally called the equity capitalization rate. But in general, it is just the discount rate,
the rate at which dividends are discounted to determine the price of the stock.

What we do not know at this point is what rate to use. All we can say for sure is that it is more
than the rate of return on a risk-free investment, such as a short-term government security.

The value of a stock or a bond is the price at which it would be expected to trade in the financial
markets. For stocks, the value or price is what management should focus on. Maximizing the
stock price should be the goal of management.
Financial Management Principle 7

The price of a stock can be viewed as the value of an infinite stream of constant earnings
plus the value of its growth opportunities, the latter of which is determined by what the
company earns on its reinvested earnings in relation to the rate that its shareholders
require to invest in the stock.

When companies generate earnings, they have two choices of what to do with the funds. They
can pay dividends or reinvest the funds back into new projects. When companies are able to
reinvest at a rate higher than required by investors, the stock price will reflect this value and be
higher because of it. Conversely, if companies reinvest earnings at lower than the rate required
by their stockholders, the stock price will reflect this as well and will be lower than it would be if
the companies stopped investing these funds at inadequate returns.

The price of a stock can be thought of as consisting of two values: the value of an infinite stream
of constant earnings and the value of an infinite stream representing the growth opportunities of
the company. The latter will be positive if earnings are reinvested at higher than the
stockholders’ required rate and negative if earnings are reinvested at lower than the stockholders’
required rate.

Financial Management Principle 8

The capital investment opportunities companies have should evaluated by undertaking any
investments in which the present value of the cash inflows exceeds the present value of the
cash outflows.

Companies raise capital and invest in assets. Depending on what line of business a company is
engaged in, its investments take the form of projects, factories, new products, divisions,
machinery, or equipment. Some investments are not quite as physical, such as investing in
personnel and software. The process of investing in assets is sometimes called capital
budgeting. Whether a company should make a particular capital investment depends on whether
that investment creates value for the shareholders. Capital investments typically involve the
outlay of funds, followed by a period of cash flows, perhaps some being negative but hopefully
most being positive. Some projects could involve the generation of cash at the start followed by
cash outflows later, such as being paid first to provide a product or service that will incur costs
while providing it. Regardless of the case, however, a capital investment should be undertaken if
and only if it adds value. Value is added if the present value of the inflows exceeds the present
value of the outflows. The present value of the inflows minus the present value of the outflows
is typically called the net present value.
The concept of net present value is the idea that you determine the present value of the cash
flows over the life of the contract and subtract the initial outlay. Because the initial outlay, by
definition, occurs today, we do not explicitly find its present value. The initial outlay is its
present value. But the term net present value has been around so long that it is standard
terminology, and we have to use it. But what we are doing is simply finding the present value of
all cash flows of a project. Some cash flows will be outflows, and some will be inflows. Some
will occur today, some will occur later. But the general idea is the same: if the present value of
all cash flows, positive and negative, is positive, then the project adds value.

Certain other decision criteria, such as payback period, profitability index, and internal rate of
return are widely used in practice. These techniques will sometimes lead to the correct decision
but not always. The correct decision is always the one that adds value to the shareholders. Net
present value is the only criterion guaranteed to lead to the correct decision all of the time.

Financial Management Principle 9

When determining the cash flows associated with a capital investment decision, only
incremental cash flows should be counted, accounting profits are necessary only to
determine taxes, an increase in working capital is effectively the same as an outlay of cash,
capital investments must be depreciated and the faster the better, tax losses generate
credits that are typically assumed to reduce tax payments elsewhere in the firm and
thereby increase cash flow, and the sale of an investment can result in taxes if the selling
price differs from the book value.

New investments must create value on their own. They cannot be credited with value created by
existing projects. Hence, we consider only incremental cash flows, i.e., those that arise strictly
as a result of the new project.

The net income created by a new project is virtually meaningless. Net income is important only
in that it is derived taxable income, which is necessary to determine the taxes. Taxes are a
definite cash flow. Net income is not cash flow.

Because accounting figures such as sales, cost of goods sold, and other expenses are not actual
cash flows, adjustments must be made. Sales that are made but not collected will result in an
increase in receivables but not cash. Inventory purchases and other expenses not paid in cash are
counted as expenses but increase payables. To convert accounting figures into cash flow,
increases in net working capital must be accounted for as though they were cash outlays. That is,
deducting increases in working capital convert accounting figures to cash figures.

Unlike short-term expenses, capital investment expenditures cannot be deducted from pre-tax
income. They must be depreciated. It is to the company’s advantage to write off its expenses as
fast as possible. Accelerated depreciation is better than straight-line depreciation, because the
cost of the investment is written off earlier, which reduces the present value of taxes.

If taxable income turns out to be a loss, we still multiply it by the tax rate. The resulting figure is
a negative tax and can be viewed as a tax credit. This means that the application of this loss to
the firm’s other income reduces the overall taxes by the amount of the tax credit.

If an asset is sold at a value different from its book value (cost minus accumulated depreciation),
there is a taxable gain or loss. We must compute the tax and subtract it if a taxable gain or add it
if a taxable loss to the sale price to get the net sale price of the asset.

Financial Management Principle 10

If investors are rational, they should fully diversify by holding the market portfolio, which
is the portfolio of all risky securities available for investment.

Securities, which refer to stocks and bonds, have two primary types of risks: diversifiable and
undiversifiable. The diversifiable risk of a security is the risk that arises from the specific
performance of the company. If investors hold diversified portfolios, this risk can be completely
eliminated. All investors should hold the most broadly diversified portfolios possible. These
broadly diversified portfolios, however, will be subject to whatever risks remains that reflects the
common risks of these companies. These common risks are said to be undiversifiable and are
generally related to the economy as a whole.

A portfolio that is so broad that all of the diversifiable risk is eliminated is typically considered
to be the portfolio of all risky securities in the market and is often called the market portfolio. As
a practical matter, it is impossible to hold the true market portfolio, but very broadly diversified
mutual funds are not only available, but are widely held by investors.

Diversifiable risk is also called specific risk, unique risk, idiosyncratic risk, and unsystematic
risk. Undiversifiable risk is also called market risk and systematic risk.
Financial Management Principle 11

If investors hold the market portfolio of risky assets, the expected returns on individual
assets are determined solely by the risk-free rate, the premium one would expect by
investing in the market portfolio, and the risk of the specific investment relative to the
market portfolio.

The risk remaining in the market portfolio reflects the correlation or covariance of the security
with the market portfolio and is called the beta. The beta risk indicates how sensitive the
security is to movements in the market portfolio. Beta risk is rewarded in that an investor can
expect to earn a greater return the more of this risk accepted. Diversifiable risk is not rewarded
because it can be completely eliminated. That is, you cannot expect to earn a higher return for
accepting diversifiable risk.

The model that gives us this relationship is called the Capital Asset Pricing Model or CAPM.
Most people believe that this model is not a completely accurate picture of what happens in the
market but that it is approximately correct and useful enough for companies to apply.

Financial Management Principle 12

The rate at which a company should discount risky cash flows when making a capital
investment decision should be the rate that its shareholders would use if they were
investing directly in the project.

The company is entrusted with the shareholders’ money and charged with increasing its
shareholders' wealth. When the company invests in assets, the shareholders are indirectly
investing in assets. The company should decide whether to invest in an asset the same way the
shareholders would decide. Given the principles of diversification and the CAPM, we know how
our shareholders would think if they were considering investing in the same project that we, the
company’s management, are considering investing in for the company. Therefore, we should
evaluate the decision the same way the shareholders would.

Thus, the discount rate on the project should be the same as it would be if the project traded like
a stock. To estimate this rate, we might consider estimating the project’s beta and using the
CAPM to obtain the expected return. Alternatively, we might search for a publicly traded
company that is similar to the project in question and use the return its shareholders expect.
Although this statement refers to "risky" cash flows, it also applies to risk-free cash flows,
because shareholders would discount risk-free cash flows at the risk-free rate, which is the rate
the company should use.

Financial Management Principle 13

Financial markets are relatively efficient, meaning that it is nearly impossible for an
investor to consistently earn a return that exceeds the expected return that the investor
should earn given the risk.

This statement effectively says that investors who trade in financial markets can expect to earn
returns that are appropriate for the risk they assume. Financial markets are efficient because they
are so competitive and information is fairly inexpensive. Thousands of investors continuously
comb through the market looking for small bits of relevant information. When they find
something useful, they trade on it and the information is rapidly incorporated into the prices of
securities. Market efficiency results when no single investor can consistently earn returns that
exceed the returns that are fair given the risk assumed. Any such returns that exceed those that
are fair given the risk are called abnormal returns, excess returns, or alpha. On average, alphas
are zero for all investors.

Of course whenever new information is discovered, someone will hear of it first and will
unquestionably earn abnormal returns. Market efficiency does not rule out abnormal returns. It
rules out only the fact that no single investor can earn them consistently. Of course, some very
successful investors do appear to have earned abnormal returns. The existence of these investors
could be because the theory is wrong or it could be because these investors are lucky. Luck has
tremendous power to explain abnormal performance. Given a large enough set of competitors, a
surprisingly large number will achieve remarkable results just through luck.

Financial market efficiency has important implications for companies when they think about
issuing stock and bonds.
Financial Management Principle 14

In a world of no taxes, transaction costs or other frictions, companies can generate no

benefits for their shareholders by using any specific amount of debt relative to equity.

This statement means that the capital structure decision – how much debt to use relative to equity
– is irrelevant. Companies should not waste time trying to figure out what is the best level of
debt. This result is a direct consequence of the efficiency of financial markets. If markets are
competitive and efficient, then we know that investors cannot earn abnormal returns from trading
securities. It follows that companies cannot earn abnormal returns from issuing securities.
Regardless of what combination of debt and equity is used, the shareholders do not benefit.

One of the strongest arguments supporting this point is the fact that with respect to the buying
and selling of securities, companies cannot do anything for their shareholders that the
shareholders cannot do for themselves. If a company without any debt issues some debt, it has
effectively put its shareholders in the position of being borrowers. If the shareholders wanted to
be borrowers, they could have simply borrowed on their own. If shareholders of companies with
debt wanted to reduce their debt, they could reduce their personal borrowings. Thus, with
respect to issuing securities, anything companies do on behalf of their shareholders could be
done directly by the shareholders.

Some argue that debt is cheaper than equity so it should be preferred. Indeed it is true that the
cost of debt is less than the cost of equity. But using debt increases the risk to the shareholders.
Hence, its lower cost raises the cost of equity, and the effects cancel out.

An alternative way of looking at this point is to think of the company as a pie. Creditors get an
agreed-upon piece of the pie, and the shareholders get what is left. To benefit the shareholders,
the company should try to make the pie larger. The creditors get the same size piece, so the
excess goes to the shareholders. But slicing the pie a different way, i.e., using more or less debt,
has no effect on the shareholders.

To make the pie larger, companies should focus on their asset decisions, which is the capital
investment decision. We have already demonstrated that positive-NPV projects benefit the
shareholders. Financial market efficiency and its consequence – the irrelevance of the capital
structure decision – are simply statements that mean that it is impossible for a company to
generate positive NPVs by selling and buying its own securities.
Financial Management Principle 15

Taking into account taxes and other market imperfections, there could indeed by an
optimal amount of debt for companies to use.

In the presence of taxes and certain other factors, capital structure decisions might not be
irrelevant. Taxes, in particular, create a preference for debt over equity. Interest on debt is
deductible but dividends are not. Also, corporations might have an advantage issuing debt over
their shareholders issuing debt if corporations can do it less expensively. Corporations could
also have information their shareholders do not have. For example, a corporation might choose
to borrow less than would its shareholders because it is concerned about its ability to repay the
debt, a fact possibly unknown to the shareholders.

The possibility of bankruptcy can reduce the amount of debt a company uses. It is not, however,
bankruptcy per se that limits a company’s use of debt. It is bankruptcy costs, which are the costs
paid to the legal system to administer the bankruptcy process. Remembering the firm as a pie,
the creditors and owners supply the ingredients that make up the pie. They take the risk and
expect to earn a reasonable return. The legal system does not, however, put up any capital. If
bankruptcy occurs, however, the legal system earns a return without taking any risk. The
possibility of this third party – the legal system – having a claim on the firm’s assets can cause
firms to limit their use of debt.

Agency costs can affect the use of debt, because creditors serve as monitors of management. By
having debt, companies obtain low-cost monitoring that helps keep an eye on management.

All in all, most companies use debt, thereby taking advantage of the tax deductibility of interest.
Some use far too little debt and some probably use far too much. Many companies adhere to a
type of pecking-order explanation of capital structure. When funds are needed, companies look
to internally generated funds first. While this type of funding is equity, it comes with the fewest
strings attached. It does not required diluting current shareholders’ investment and does not
bring in new creditors to monitor management. Raising funds this way incurs virtually no
transaction costs. The second source of funds is generally new debt, and the third source is
generally new equity. New equity is the least desirable because it dilutes the owner’s
investment. Also, some studies show that firms issue new equity when they think the stock is
overvalued. Thus, the stock market tends to react negatively when new equity is issued. New
debt falls in the middle of the pecking order.

Whether there is an optimal amount of debt to use is a challenging question to which no one
really knows the answer.
Financial Management Principle 16

With no taxes or market imperfections and assuming constant investment strategy, the
dividends paid by a company are largely irrelevant in determining the value of the
company.

Hence, dividend policy cannot improve the wealth of shareholders. This statement should come
as a surprise. We already learned that the prices of stocks and bonds are the present values of
their streams of future cash flows. For stocks, these streams are represented by their dividends.
Now we say that it does not matter what dividends companies pay. In fact, companies could pay
no dividends at all.

Indeed the stock price is the present value of its future dividends. No company can simply refuse
to ever pay dividends. If a company took its shareholders money and refused to ever return it,
the stock price would be zero. Companies that do not pay dividends are really just companies
that are not currently paying dividends.

Most finance textbooks say that in a perfect market it does not matter whether companies pay
dividends now or reinvest those dividends. Reinvested dividends increase expected future
dividends later. This is the essence of the dividend irrelevance result. Investors who want
dividends and are not getting them can just sell some of their shares to generate the cash. Those
who are getting dividends and do not want them can simply reinvest their dividends into new
shares. Indeed, reinvestment of dividends is extremely common.

The result that dividend policy is irrelevant is technically true only if companies are able to
reinvest their dividends in projects that earn at least zero NPV. That is, we must hold the
company’s asset investment policy constant by assuming that the company can invest in projects
that have zero NPV. If companies cannot reinvest dividends into projects that earn at least zero
NPV, then they should indeed pay more dividends. They should pay out all of their money in
dividends. By contrast, companies that can reinvest dividends into projects with positive NPVs
should pay lower dividends. In fact, they should pay no dividends at all. If, however, the use of
debt is indeed irrelevant, they can pay dividends by borrowing the money to generate enough
cash to pay dividends and have enough to fund their capital investments.

But why would they want to do so? Only if dividends do matter. The reality is that dividends
can matter. Dividends are thought to serve as a signal to investors that the company is doing
well. When companies cut dividends, investors usually react by lowering the price of the stock.
The dividend reduction is seen as a signal that bad times lie ahead. Companies typically pay
fairly constant dividends and raise dividends only when they know they can sustain the dividends
at the higher level. They cut dividends only as a last resort.

Companies that have a lot of cash and not a lot of positive NPV opportunities but who do not
want to pay out dividends often return cash to their shareholders by repurchasing shares. Share
repurchase does not increase shareholder wealth, but it can be a good use of cash that would
otherwise sit idle or be squandered by management.

inancial Management Principle 17

If capital gains are taxed at more attractive rates than dividends, which has been the case
often in the U. S., dividends are an inferior way for shareholders to receive returns.

Under current U.S. tax laws, dividends and capital gains are taxed almost equally. But if capital
gains are taxed favorably to dividends, as they have been at times in the past, companies could
want to keep their dividends down.

Even under equal taxation of dividends and capital gains, dividends can be taxed unfavorably to
capital gains. Capital gains taxes can be deferred by selling at a later date. Indeed, investors can
decide when to sell stocks and incur capital gains taxes. Investors have no control over the
receipt of dividends. Some capital gains taxes can even be deferred indefinitely by donating the
stock to a non-profit organization. Also, if the stockholder dies, the accumulated capital gains
taxes go away, because the heirs are taxed only on the accumulated capital gains after they
acquire the stock.

The only requirement for a stock to qualify for capital gains taxes is that it be held at least one
year. This is not a particularly onerous requirement. There are, however, some limits to the tax
deductibility of capital gains. Capital losses offset capital gains, and only the net is taxed. If
losses exceed gains, only $3,000 per year can be applied to other income. The remainder must
be carried forward to reduce future gains and is therefore worth somewhat less as a tax credit.

Thus, it will nearly always be the case that capital gains will be preferred over dividends by
shareholders. This point is consistent with the fact that most firms pay far lower dividends than
they could, although it may not be the only reason why.
Financial Management Principle 18

Although there are many different types of securities issued by firms, the gains from
issuing different types of securities are somewhat limited and largely based on the mistaken
belief by some investors that these securities can be used to earn abnormal returns.

There are different types of equity, such as common stock, warrants, and preferred stock. There
are different types of common stock, such as voting and nonvoting common stock. There are
also many more different types of debt securities, such as bonds with sinking funds, callable
bonds, convertible bonds, equipment trust certificates, and asset-backed bonds. In addition,
some financing can be obtained through leasing, which is a commitment to incur a fixed expense
to obtain use of an asset and is almost the same as debt.

All of these instruments have advantages and disadvantages and costs and benefits. Their appeal
is often based on the notion that some investors want these specific types of securities and will
pay attractive prices for them. Their existence is something of a contradiction to the efficient
market notion and the idea that capital structure does not matter. If companies can creatively
package claims in such a manner that an investor receives something he could not get otherwise,
then this type of creative financing can benefit a company's shareholders. But it is important to
note that this benefit arises largely from a belief on the part of the investor who buys the security
that he can earn an abnormal return from it. Alternatively there may be some tax advantage to
this special security. But tax advantages are rarely long-lived. In the long run, these securities
exist primarily to meet the needs of investors who believe they can earn abnormal returns with
them. These investors are likely misguided. But as long as they are misguided, companies
should continue to exploit them by creating and using these types of securities.
Financial Management Principle 19

Except in a few circumstances corporate diversification, such as through mergers,

acquisitions, takeovers or simply through investing in projects that are unrelated to their
firm’s existing projects, provides no gains for shareholders.

Companies are constantly acquiring other assets and sometimes other companies in an effort to
diversify. Starting with mergers, it is easy to see that this activity usually does nothing for
shareholders that they could not do themselves. Consider Company A that acquires Company
B. If the shareholders of Company A wanted to own Company B, they could simply buy the
stock of Company B. The merger does nothing for the shareholders. In fact, it may hurt the
shareholders, because companies expend large amounts of money for advice from investment
bankers and lawyers. Also, managers, time is spread thin when managing a larger company. In
contrast, the shareholders can acquire the stock of the other company at far less cost. Mergers
can also be costly in other ways. Can the management of Company A successfully manage
Company B? Can it integrate Company B into Company A?

Yet mergers occur frequently. Why? Mergers can potentially create value through synergy. If
the combined company, A and B, can do things more efficiently that they two companies
separately, there may be gains. Oftentimes these gains arise simply from cost reductions through
firing employees. Sometimes gains can occur if the management of the acquired firm is doing a
poor job but is so entrenched that the shareholders cannot get rid of it. Takeovers force a
discipline on firms to do a good job or be taken over by an outside firm. Of course, the deposed
management of the acquired firm does usually walk away with a nice severance package.

Other than with mergers, companies often diversify by entering into capital investment projects
that are unrelated to their current lines of business. This type of activity is quite common. If
companies carry it to the extreme, they become so broadly diversified they are called
conglomerates. GE is an excellent example. Its products are primarily considered industrial and
technological, but it is also a large financial institution and is in the healthcare industry and in
entertainment. Are these activities beneficial to its shareholders? As with mergers, the answer is
yes only if the diversifying activity can create value by combining with the company’s existing
activities in such a way as to provide the combined products and services with greater efficiency.

Many diversifying activities take place because of empire-building. Managers seem to often
want more power and one way to get it is to cause their companies to get larger. Also,
diversification has a significant benefit to management. Since most management personnel are
heavily compensated with shares and options, their personal portfolios are poorly diversified.
Diversification at the corporate level reduces the risk of managers’ personal portfolios and the
risks of the managers' reputation from being connected with the company.

Firms should generally not engage in these types of diversifying activities unless the activities
clearly create value for the shareholders.
Financial Management Principle 20

Options, which are financial instruments that grant the right to one party to acquire
something from another party or sell something to another party at a fixed price, are
widely seen in the financial world.

Options are best viewed as the rights to do something, such as buy or sell. Investors trade
options on the stocks of companies in a large and active market. Companies often use options to
give employees and management incentives to continue working for the company and to work
harder. Many capital investment projects have implicit options to make changes to the projects.
Equity can be viewed as an option in that paying off debt is like buying the assets from the
creditors for the price promised, the face value of the debt.

Options have value, sometimes great value. If there is any doubt about that, ask yourself
whether you would be willing to give one away. In the study of finance, we learn how to
determine what an option is worth and how they should be used.