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brealey-meyers principles of corporate finance seventh edition front matter preface © the mcgraw-hill companies 2003 preface this book describes the theory and practice of corporate finance we hardly need to explain why financial managers should master the practical aspects of their job but we should spell out why down-to-earth redblooded managers need to bother with theory managers learn from experience how to cope with routine problems but the best managers are also able to respond to change to do this you need more than time-honored rules of thumb you must understand why companies and financial markets behave the way they do in other words you need a theory of finance does that sound intimidating it shouldn t good theory helps you grasp what is going on in the world around you it helps you to ask the right questions when times change and new problems must be analyzed it also tells you what things you do not need to worry about throughout this book we show how managers use financial theory to solve practical problems of course the theory presented in this book is not perfect and complete no theory is there are some famous controversies in which financial economists cannot agree on what firms ought to do we have not glossed over these controversies we set out the main arguments for each side and tell you where we stand once understood good theory is common sense therefore we have tried to present it at a commonsense level and we have avoided proofs and heavy mathematics there are no ironclad prerequisites for reading this book except algebra and the english language an elementary knowledge of accounting statistics and microeconomics is helpful however changes in the seventh edition this book is written for students of financial management for many readers it is their first look at the world of finance therefore in each edition we strive to make the book simpler clearer and more fun to read but the book is also used as a reference and guide by practicing managers around the world therefore we also strive to make each new edition more comprehensive and authoritative we believe this edition is better for both the student and the practicing manager here are some of the major changes we have streamlined and simplified the exposition of major concepts with special attention to chapters 1 through 12 where the fundamental concepts of valuation risk and return and capital budgeting are introduced in these chapters we cover only the most basic institutional material at the ix

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brealey-meyers principles of corporate finance seventh edition front matter preface © the mcgraw-hill companies 2003 x preface of course as every first-grader knows it is easier to add than to subtract but we have pruned judiciously some readers of the sixth edition may miss a favorite example or special topic but new readers should find that the main themes of corporate finance come through with less clutter same time we have rewritten chapter 14 as a freestanding introduction to the nature of the corporation to the major sources of corporate financing and to financial markets and institutions some readers will turn first to chapter 14 to see the contexts in which financial decisions are made we have also expanded coverage of important topics for example real options are now introduced in chapter 10 you don t have to master optionpricing theory in order to grasp what real options are and why they are important later in the book after chapter 20 understanding options and chapter 21 valuing options there is a brand-new chapter 22 on real options which covers valuation methods and a range of practical applications other examples of expanded coverage include behavioral finance chapter 13 and new international evidence on the market-risk premium chapter 7 we have also reorganized the chapters on financial planning and working capital management in fact we have revised and updated every chapter in the book this edition s international coverage is expanded and woven into the rest of the text for example international investment decisions are now introduced in chapter 6 right alongside domestic investment decisions likewise the cost of capital for international investments is discussed in chapter 9 and international differences in security issue procedures are reviewed in chapter 15 chapter 34 looks at some of the international differences in financial architecture and ownership there is however a separate chapter on international risk management which covers foreign exchange rates and markets political risk and the valuation of capital investments in different currencies there is also a new international index the seventh edition is much more web-friendly than the sixth web references are highlighted in the text and an annotated list of useful websites has been added to each part of the book making learning easier each chapter of the book includes an introductory preview a summary and an annotated list of suggestions for further reading there is a quick and easy quiz a number of practice questions and a few challenge questions many questions use financial data on actual companies accessible by the reader through standard poor s educational version of market insight in total there are now over a thousand end-of-chapter questions all the questions refer to material in the same order as it occurs in the chapter answers to the quiz questions may be found at the end of the book along with a glossary and tables for calculating present values and pricing options we have expanded and revised the mini-cases and added specific questions for each mini-case to guide the case analysis answers to the mini-cases are available to instructors on this book s website www.mhhe.com/bm7e parts 1 to 3 of the book are concerned with valuation and the investment decision parts 4 to 8 with long-term financing and risk management part 9 focuses on financial planning and short-term financial decisions part 10 looks at mergers and corporate control and part 11 concludes we realize that many teachers will prefer a different sequence of topics therefore we have ensured that the text is modular so that topics can be introduced in a variety of orders for example there will be no difficulty in reading the material on financial statement analysis and shortterm decisions before the chapters on valuation and capital investment.

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brealey-meyers principles of corporate finance seventh edition front matter preface © the mcgraw-hill companies 2003 preface we should mention two matters of style now to prevent confusion later first the most important financial terms are set out in boldface type the first time they appear less important but useful terms are given in italics second most algebraic symbols representing dollar values are shown as capital letters other symbols are generally lowercase letters thus the symbol for a dividend payment is div and the symbol for a percentage rate of return is r xi financial analysis spreadsheet templates f.a.s.t mike griffin of kmt software created the templates in excel they correlate with specific concepts in the text and allow students to work through financial problems and gain experience using spreadsheets each template is tied to a specific problem in the text solutions manual isbn 0072468009 supplements in this edition we have gone to great lengths to ensure that our supplements are equal in quality and authority to the text itself the solutions manual prepared by bruce swensen adelphi university contains solutions to all practice questions and challenge questions found at the end of each chapter thoroughly checked for accuracy this supplement is available to be purchased by your students instructor s manual isbn 0072467886 the instructor s manual was extensively revised and updated by c r krishnaswamy of western michigan university it contains an overview of each chapter teaching tips learning objectives challenge areas key terms and an annotated outline that provides references to the powerpoint slides study guide isbn 0072468017 the new study guide was carefully revised by v sivarama krishnan of cameron university and contains useful and interesting keys to learning it includes an introduction to each chapter key concepts examples exercises and solutions and a complete chapter summary test bank isbn 0072468025 the test bank was also updated by c r krishnaswamy who included well over 1,000 new multiplechoice and short answer/discussion questions based on the revisions of the authors the level of difficulty is varied throughout using a label of easy medium or difficult videos isbn 0072467967 the mcgraw-hill/irwin finance video series is a complete video library designed to bring added points of discussion to your class within this professionally developed series you will find examples of how real businesses face today s hottest topics like mergers and acquisitions going public and careers in finance powerpoint presentation system matt will of the university of indianapolis prepared the powerpoint presentation system which contains exhibits outlines key points and summaries in a visually stimulating collection of slides found on the student cd-rom the instructor s cd-rom and our website the slides can be edited printed or rearranged in any way to fit the needs of your course student cd-rom packaged with each text is a cd-rom for students that contains many features designed to enhance the classroom experience three learning modules from the new finance tutor series are included on the cd time value of money tutor stock and bond valuation

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brealey-meyers principles of corporate finance seventh edition front matter preface © the mcgraw-hill companies 2003 xii preface html a universal web language next choose your favorite of three easy-to-navigate designs and your web home page is created complete with online syllabus lecture notes and bookmarks you can even include a separate instructor page and an assignment page pageout offers enhanced point-and-click features including a syllabus page that applies real-world links to original text material an automated grade book and a discussion board where instructors and their students can exchange questions and post announcements tutor and capital budgeting tutor in each module students answer questions and solve problems that not only assess their general understanding of the subject but also their ability to apply that understanding in real-world business contexts in practice mode students learn as they go by receiving indepth feedback on each response before proceeding to the next question even better the program anticipates common misunderstandings such as incorrect calculations or assumptions and then provides feedback only to the student making that specific mistake students who want to assess their current knowledge may select test mode where they read an extensive evaluation report after they have completed the test also included are the powerpoint presentation system financial analysis spreadsheet templates f.a.s.t video clips from our finance video series and many useful web links acknowl edgments we have a long list of people to thank for their helpful criticism of earlier editions and for assistance in preparing this one they include aleijda de cazenove balsan john cox kedrum garrison robert pindyck and gretchen slemmons at mit stefania uccheddu at london business school lynda borucki marjorie fischer larry kolbe james a read jr and bente villadsen at the brattle group inc john stonier at airbus industries and alex triantis at the university of maryland we would also like to thank all those at mcgraw-hill/irwin who worked on the book including steve patterson publisher rhonda seelinger executive marketing manager sarah ebel senior developmental editor jean lou hess senior project manager keith mcpherson design director joyce chappetto supplement coordinator and michael mccormick senior production supervisor we want to express our appreciation to those instructors whose insightful comments and suggestions were invaluable to us during this revision noyan arsen koc university penny belk loughborough university eric benrud university of baltimore peter berman university of new haven jean canil university of adelaide robert everett johns hopkins university instructor s cd-rom isbn 0072467959 we have compiled many of our instructor supplements in electronic format on a cd-rom designed to assist with class preparation the cd-rom includes the instructor s manual the solutions manual a computerized test bank powerpoint slides video clips and web links online learning center www.mhhe.com/bm7e this site contains information about the book and the authors as well as teaching and learning materials for the instructor and the student including pageout the course website development center and pageout lite www.pageout.net this web page generation software free to adopters is designed for professors just beginning to explore website options in just a few minutes even the most novice computer user can have a course website simply type your material into the template provided and pageout lite instantly converts it to

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brealey-meyers principles of corporate finance seventh edition front matter preface © the mcgraw-hill companies 2003 preface winfried hallerbach erasmus university rotterdam milton harris university of chicago mark griffiths thunderbird american school of international management jarl kallberg nyu stern school of business steve kaplan university of chicago ken kim university of wisconsin milwaukee c r krishnaswamy western michigan university ravi jaganathan northwestern university david lovatt university of east anglia joe messina san francisco state university dag michalson bl oslo peter moles university of edinburgh claus parum copenhagen business school narendar v rao northeastern university tom rietz university of iowa robert ritchey texas tech university mo rodriguez texas christian university john rozycki drake university brad scott webster university bernell stone brigham young university shrinivasan sundaram ball state university avanidhar subrahmanyam ucla stephen todd loyola university chicago david vang st thomas university john wald rutgers university jill wetmore saginaw valley state university matt will johns hopkins university art wilson george washington university xiii this list is almost surely incomplete we know how much we owe to our colleagues at the london business school and mit s sloan school of management in many cases the ideas that appear in this book are as much their ideas as ours finally we record the continuing thanks due to our wives diana and maureen who were unaware when they married us that they were also marrying the principles of corporate finance richard a brealey stewart c myers

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brealey-meyers principles of corporate finance seventh edition i value 1 finance and the financial manager © the mcgraw-hill companies 2003 chapter one finance and the financial manager 2

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brealey-meyers principles of corporate finance seventh edition i value 1 finance and the financial manager © the mcgraw-hill companies 2003 this book is about financial decisions made by corporations we should start by saying what these decisions are and why they are important corporations face two broad financial questions what investments should the firm make and how should it pay for those investments the first question involves spending money the second involves raising it the secret of success in financial management is to increase value that is a simple statement but not very helpful it is like advising an investor in the stock market to buy low sell high the problem is how to do it there may be a few activities in which one can read a textbook and then do it but financial management is not one of them that is why finance is worth studying who wants to work in a field where there is no room for judgment experience creativity and a pinch of luck although this book cannot supply any of these items it does present the concepts and information on which good financial decisions are based and it shows you how to use the tools of the trade of finance we start in this chapter by explaining what a corporation is and introducing you to the responsibilities of its financial managers we will distinguish real assets from financial assets and capital investment decisions from financing decisions we stress the importance of financial markets both national and international to the financial manager finance is about money and markets but it is also about people the success of a corporation depends on how well it harnesses everyone to work to a common end the financial manager must appreciate the conflicting objectives often encountered in financial management resolving conflicts is particularly difficult when people have different information this is an important theme which runs through to the last chapter of this book in this chapter we will start with some definitions and examples 1.1 what is a corporation not all businesses are corporations small ventures can be owned and managed by a single individual these are called sole proprietorships in other cases several people may join to own and manage a partnership.1 however this book is about corporate finance so we need to explain what a corporation is almost all large and medium-sized businesses are organized as corporations for example general motors bank of america microsoft and general electric are corporations so are overseas businesses such as british petroleum unilever nestlé volkswagen and sony in each case the firm is owned by stockholders who hold shares in the business when a corporation is first established its shares may all be held by a small group of investors perhaps the company s managers and a few backers in this case the shares are not publicly traded and the company is closely held eventually when the firm grows and new shares are issued to raise additional capital its shares will be widely traded such corporations are known as public companies 1 many professional businesses such as accounting and legal firms are partnerships most large investment banks started as partnerships but eventually these companies and their financing needs grew too large for them to continue in this form goldman sachs the last of the leading investment-bank partnerships issued shares and became a public corporation in 1998 3

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brealey-meyers principles of corporate finance seventh edition i value 1 finance and the financial manager © the mcgraw-hill companies 2003 4 part i value most well-known corporations in the united states are public companies in many other countries it s common for large companies to remain in private hands by organizing as a corporation a business can attract a wide variety of investors some may hold only a single share worth a few dollars cast only a single vote and receive a tiny proportion of profits and dividends shareholders may also include giant pension funds and insurance companies whose investment may run to millions of shares and hundreds of millions of dollars and who are entitled to a correspondingly large number of votes and proportion of profits and dividends although the stockholders own the corporation they do not manage it instead they vote to elect a board of directors some of these directors may be drawn from top management but others are non-executive directors who are not employed by the firm the board of directors represents the shareholders it appoints top management and is supposed to ensure that managers act in the shareholders best interests this separation of ownership and management gives corporations permanence.2 even if managers quit or are dismissed and replaced the corporation can survive and today s stockholders can sell all their shares to new investors without disrupting the operations of the business unlike partnerships and sole proprietorships corporations have limited liability which means that stockholders cannot be held personally responsible for the firm s debts if say general motors were to fail no one could demand that its shareholders put up more money to pay off its debts the most a stockholder can lose is the amount he or she has invested although a corporation is owned by its stockholders it is legally distinct from them it is based on articles of incorporation that set out the purpose of the business how many shares can be issued the number of directors to be appointed and so on these articles must conform to the laws of the state in which the business is incorporated.3 for many legal purposes the corporation is considered as a resident of its state as a legal person it can borrow or lend money and it can sue or be sued it pays its own taxes but it cannot vote because the corporation is distinct from its shareholders it can do things that partnerships and sole proprietorships cannot for example it can raise money by selling new shares to investors and it can buy those shares back one corporation can make a takeover bid for another and then merge the two businesses there are also some disadvantages to organizing as a corporation managing a corporation s legal machinery and communicating with shareholders can be time-consuming and costly furthermore in the united states there is an important tax drawback because the corporation is a separate legal entity it is taxed separately so corporations pay tax on their profits and in addition shareholders pay tax on any dividends that they receive from the company the united states is unusual in this respect to avoid taxing the same income twice most other countries give shareholders at least some credit for the tax that the company has already paid.4 2 corporations can be immortal but the law requires partnerships to have a definite end a partnership agreement must specify an ending date or a procedure for wrapping up the partnership s affairs a sole proprietorship also will have an end because the proprietor is mortal 3 delaware has a well-developed and supportive system of corporate law even though they may do little business in that state a high proportion of united states corporations are incorporated in delaware 4 or companies may pay a lower rate of tax on profits paid out as dividends.

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brealey-meyers principles of corporate finance seventh edition i value 1 finance and the financial manager © the mcgraw-hill companies 2003 chapter 1 finance and the financial manager 5 1.2 the role of the financial manager to carry on business corporations 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 need to be paid for to obtain the necessary money the corporation sells claims on its real assets and on the cash those assets will generate these claims are called financial assets or securities for example if the company borrows money from the bank the bank gets a written promise that the money will be repaid with interest thus the bank trades cash for a financial asset financial assets include not only bank loans but also shares of stock bonds and a dizzying variety of specialized securities.5 the financial manager stands between the firm s operations and the financial or capital markets where investors hold the financial assets issued by the firm.6 the financial manager s role is illustrated in figure 1.1 which traces the flow of cash from investors to the firm and back to investors again the flow starts when the firm sells securities to raise cash arrow 1 in the figure the cash is used to purchase real assets used in the firm s operations arrow 2 later if the firm does well the real assets generate cash inflows which more than repay the initial investment arrow 3 finally the cash is either reinvested arrow 4a or returned to the investors who purchased the original security issue arrow 4b of course the choice between arrows 4a and 4b is not completely free for example if a bank lends money at stage 1 the bank has to be repaid the money plus interest at stage 4b our diagram takes us back to the financial manager s two basic questions first what real assets should the firm invest in second how should the cash for the investment be raised the answer to the first question is the firm s investment or capital budgeting decision the answer to the second is the firm s financing decision capital investment and financing decisions are typically separated that is analyzed independently when an investment opportunity or project is identified the financial manager first asks whether the project is worth more than the capital required to undertake it if the answer is yes he or she then considers how the project should be financed but the separation of investment and financing decisions does not mean that the financial manager can forget about investors and financial markets when analyzing capital investment projects as we will see in the next chapter the fundamental financial objective of the firm is to maximize the value of the cash invested in the firm by its stockholders look again at figure 1.1 stockholders are happy to contribute cash at arrow 1 only if the decisions made at arrow 2 generate at least adequate returns at arrow 3 adequate means returns at least equal to the returns available to investors outside the firm in financial markets if your firm s projects consistently generate inadequate returns your shareholders will want their money back financial managers of large corporations also need to be men and women of the world they must decide not only which assets their firm should invest in but also where those assets should be located take nestlé for example it is a swiss company but only a small proportion of its production takes place in switzerland its 520 or so we review these securities in chapters 14 and 25 you will hear financial managers use the terms financial markets and capital markets almost synonymously but capital markets are strictly speaking the source of long-term financing only short-term financing comes from the money market short-term means less than one year we use the term financial markets to refer to all sources of financing 6 5

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brealey-meyers principles of corporate finance seventh edition i value 1 finance and the financial manager © the mcgraw-hill companies 2003 6 part i value figure 1.1 2 flow of cash between financial markets and the firm s operations key 1 cash raised by selling financial assets to investors 2 cash invested in the firm s operations and used to purchase real assets 3 cash generated by the firm s operations 4a cash reinvested 4b cash returned to investors 1 financial manager financial markets investors holding financial assets firm s operations a bundle of real assets 3 4a 4b factories are located in 82 countries nestlé s managers must therefore know how to evaluate investments in countries with different currencies interest rates inflation rates and tax systems the financial markets in which the firm raises money are likewise international the stockholders of large corporations are scattered around the globe shares are traded around the clock in new york london tokyo and other financial centers bonds and bank loans move easily across national borders a corporation that needs to raise cash doesn t have to borrow from its hometown bank day-to-day cash management also becomes a complex task for firms that produce or sell in different countries for example think of the problems that nestlé s financial managers face in keeping track of the cash receipts and payments in 82 countries we admit that nestlé is unusual but few financial managers can close their eyes to international financial issues so throughout the book we will pay attention to differences in financial systems and examine the problems of investing and raising money internationally 1.3 who is the financial manager in this book we will use the term financial manager to refer to anyone responsible for a significant investment or financing decision but only in the smallest firms is a single person responsible for all the decisions discussed in this book in most cases responsibility is dispersed top management is of course continuously involved in financial decisions but the engineer who designs a new production facility is also involved the design determines the kind of real assets the firm will hold the marketing manager who commits to a major advertising campaign is also making an important investment decision the campaign is an investment in an intangible asset that is expected to pay off in future sales and earnings nevertheless there are some managers who specialize in finance their roles are summarized in figure 1.2 the treasurer is responsible for looking after the firm s cash raising new capital and maintaining relationships with banks stockholders and other investors who hold the firm s securities for small firms the treasurer is likely to be the only financial executive larger corporations also have a controller who prepares the financial statements manages the firm s internal accounting and looks after its tax obligations you can see that the treasurer and controller have different functions the treasurer s main responsibility is to obtain and manage the firm s capital whereas the controller ensures that the money is used efficiently.

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brealey-meyers principles of corporate finance seventh edition i value 1 finance and the financial manager © the mcgraw-hill companies 2003 chapter 1 finance and the financial manager 7 chief financial officer cfo responsible for financial policy corporate planning treasurer responsible for cash management raising capital banking relationships controller responsible for preparation of financial statements accounting taxes figure 1.2 senior financial managers in large corporations still larger firms usually appoint a chief financial officer cfo to oversee both the treasurer s and the controller s work the cfo is deeply involved in financial policy and corporate planning often he or she will have general managerial responsibilities beyond strictly financial issues and may also be a member of the board of directors the controller or cfo is responsible for organizing and supervising the capital budgeting process however major capital investment projects are so closely tied to plans for product development production and marketing that managers from these areas are inevitably drawn into planning and analyzing the projects if the firm has staff members specializing in corporate planning they too are naturally involved in capital budgeting because of the importance of many financial issues ultimate decisions often rest by law or by custom with the board of directors for example only the board has the legal power to declare a dividend or to sanction a public issue of securities boards usually delegate decisions for small or medium-sized investment outlays but the authority to approve large investments is almost never delegated 1.4 separation of ownership and management in large businesses separation of ownership and management is a practical necessity major corporations may have hundreds of thousands of shareholders there is no way for all of them to be actively involved in management it would be like running new york city through a series of town meetings for all its citizens authority has to be delegated to managers the separation of ownership and management has clear advantages it allows share ownership to change without interfering with the operation of the business it allows the firm to hire professional managers but it also brings problems if the managers and owners objectives differ you can see the danger rather than attending to the wishes of shareholders managers may seek a more leisurely or luxurious

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brealey-meyers principles of corporate finance seventh edition i value 1 finance and the financial manager © the mcgraw-hill companies 2003 8 part i value working lifestyle they may shun unpopular decisions or they may attempt to build an empire with their shareholders money such conflicts between shareholders and managers objectives create principal­ agent problems the shareholders are the principals the managers are their agents shareholders want management to increase the value of the firm but managers may have their own axes to grind or nests to feather agency costs are incurred when 1 managers do not attempt to maximize firm value and 2 shareholders incur costs to monitor the managers and influence their actions of course there are no costs when the shareholders are also the managers that is one of the advantages of a sole proprietorship owner­managers have no conflicts of interest conflicts between shareholders and managers are not the only principal­agent problems that the financial manager is likely to encounter for example just as shareholders need to encourage managers to work for the shareholders interests so senior management needs to think about how to motivate everyone else in the company in this case senior management are the principals and junior management and other employees are their agents agency costs can also arise in financing in normal times the banks and bondholders who lend the company money are united with the shareholders in wanting the company to prosper but when the firm gets into trouble this unity of purpose can break down at such times decisive action may be necessary to rescue the firm but lenders are concerned to get their money back and are reluctant to see the firm making risky changes that could imperil the safety of their loans squabbles may even break out between different lenders as they see the company heading for possible bankruptcy and jostle for a better place in the queue of creditors think of the company s overall value as a pie that is divided among a number of claimants these include the management and the shareholders as well as the company s workforce and the banks and investors who have bought the company s debt the government is a claimant too since it gets to tax corporate profits all these claimants are bound together in a complex web of contracts and understandings for example when banks lend money to the firm they insist on a formal contract stating the rate of interest and repayment dates perhaps placing restrictions on dividends or additional borrowing but you can t devise written rules to cover every possible future event so written contracts are incomplete and need to be supplemented by understandings and by arrangements that help to align the interests of the various parties principal­agent problems would be easier to resolve if everyone had the same information that is rarely the case in finance managers shareholders and lenders may all have different information about the value of a real or financial asset and it may be many years before all the information is revealed financial managers need to recognize these information asymmetries and find ways to reassure investors that there are no nasty surprises on the way here is one example suppose you are the financial manager of a company that has been newly formed to develop and bring to market a drug for the cure of toetitis at a meeting with potential investors you present the results of clinical trials show upbeat reports by an independent market research company and forecast profits amply sufficient to justify further investment but the potential investors are still worried that you may know more than they do what can you do to convince them that you are telling the truth just saying trust me won t do the trick perhaps you need to signal your integrity by putting your money where your mouth is for example investors are likely to have more confidence in your plans if they see that you and the other managers have large personal stakes in the new

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brealey-meyers principles of corporate finance seventh edition i value 1 finance and the financial manager © the mcgraw-hill companies 2003 chapter 1 finance and the financial manager 9 differences in information stock prices and returns 13 issues of shares and other securities 15 18 23 dividends 16 financing 18 different objectives managers vs stockholders 2 12 33 34 top management vs operating management 12 stockholders vs banks and other lenders 18 figure 1.3 differences in objectives and information can complicate financial decisions we address these issues at several points in this book chapter numbers in parentheses enterprise therefore your decision to invest your own money can provide information to investors about the true prospects of the firm in later chapters we will look more carefully at how corporations tackle the problems created by differences in objectives and information figure 1.3 summarizes the main issues and signposts the chapters where they receive most attention 1.5 topics covered in this book we have mentioned how financial managers separate investment and financing decisions investment decisions typically precede financing decisions that is also how we have organized this book parts 1 through 3 are almost entirely devoted to different aspects of the investment decision the first topic is how to value assets the second is the link between risk and value and the third is the management of the capital investment process our discussion of these topics occupies chapters 2 through 12 as you work through these chapters you may have some basic questions about financing for example what does it mean to say that a corporation has issued shares how much of the cash contributed at arrow 1 in figure 1.1 comes from shareholders and how much from borrowing what types of debt securities do firms actually issue who actually buys the firm s shares and debt individual investors or financial institutions what are those institutions and what role do they play in corporate finance and the broader economy chapter 14 an overview of corporate financing covers these and a variety of similar questions this chapter stands on its own bottom it does not rest on previous chapters you can read it any time the fancy strikes you may wish to read it now chapter 14 is one of three in part 4 which begins the analysis of corporate financing decisions chapter 13 reviews the evidence on the efficient markets hypothesis which states that security prices observed in financial markets accurately reflect underlying values and the information available to investors chapter 15 describes how debt and equity securities are issued part 5 continues the analysis of the financing decision covering dividend policy and the mix of debt and equity financing we will describe what happens when

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brealey-meyers principles of corporate finance seventh edition i value 1 finance and the financial manager © the mcgraw-hill companies 2003 10 part i value visit us at www.mhhe.com/bm7e firms land in financial distress because of poor operating performance or excessive borrowing we will also consider how financing decisions may affect decisions about the firm s investment projects part 6 introduces options options are too advanced for chapter 1 but by chapter 20 you ll have no difficulty investors can trade options on stocks bonds currencies and commodities financial managers find options lurking in real assets that is real options and in the securities the firms may issue having mastered options we proceed in part 7 to a much closer look at the many varieties of long-term debt financing an important part of the financial manager s job is to judge which risks the firm should take on and which can be eliminated part 8 looks at risk management both domestically and internationally part 9 covers financial planning and short-term financial management we address a variety of practical topics including short and longer-term forecasting channels for short-term borrowing or investment management of cash and marketable securities and management of accounts receivable money lent by the firm to its customers part 10 looks at mergers and acquisitions and more generally at the control and governance of the firm we also discuss how companies in different countries are structured to provide the right incentives for management and the right degree of control by outside investors part 11 is our conclusion it also discusses some of the things that we don t know about finance if you can be the first to solve any of these puzzles you will be justifiably famous summary in chapter 2 we will begin with the most basic concepts of asset valuation however we should first sum up the principal points made in this introductory chapter large businesses are usually organized as corporations corporations have three important features first they are legally distinct from their owners and pay their own taxes second corporations provide limited liability which means that the stockholders who own the corporation cannot be held responsible for the firm s debts third the owners of a corporation are not usually the managers the overall task of the financial manager can be broken down into 1 the investment or capital budgeting decision and 2 the financing decision in other words the firm has to decide 1 what real assets to buy and 2 how to raise the necessary cash in small companies there is often only one financial executive the treasurer however most companies have both a treasurer and a controller the treasurer s job is to obtain and manage the company s financing while the controller s job is to confirm that the money is used correctly in large firms there is also a chief financial officer or cfo shareholders want managers to increase the value of the company s stock managers may have different objectives this potential conflict of interest is termed a principal­agent problem any loss of value that results from such conflicts is termed an agency cost of course there may be other conflicts of interest for example the interests of the shareholders may sometimes conflict with those of the firm s banks and bondholders these and other agency problems become more complicated when agents have more or better information than the principals the financial manager plays on an international stage and must understand how international financial markets operate and how to evaluate overseas investments we discuss international corporate finance at many different points in the chapters that follow.

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brealey-meyers principles of corporate finance seventh edition i value 1 finance and the financial manager © the mcgraw-hill companies 2003 chapter 1 finance and the financial manager financial managers read the wall street journal wsj the financial times ft or both daily you should too the financial times is published in britain but there is a north american edition the new york times and a few other big-city newspapers have good business and financial sections but they are no substitute for the wsj or ft the business and financial sections of most united states dailies are except for local news nearly worthless for the financial manager the economist business week forbes and fortune contain useful financial sections and there are several magazines that specialize in finance these include euromoney corporate finance journal of applied corporate finance risk and cfo magazine this list does not include research journals such as the journal of finance journal of financial economics review of financial studies and financial management in the following chapters we give specific references to pertinent research 11 further reading 2 vocabulary test explain the differences between a real and financial assets b capital budgeting and financing decisions c closely held and public corporations d limited and unlimited liability e corporation and partnership 3 which of the following are real assets and which are financial a a share of stock b a personal iou c a trademark d a factory e undeveloped land f the balance in the firm s checking account g an experienced and hardworking sales force h a corporate bond 4 what are the main disadvantages of the corporate form of organization 5 which of the following statements more accurately describe the treasurer than the controller a likely to be the only financial executive in small firms b monitors capital expenditures to make sure that they are not misappropriated c responsible for investing the firm s spare cash d responsible for arranging any issue of common stock e responsible for the company s tax affairs 6 which of the following statements always apply to corporations a unlimited liability b limited life c ownership can be transferred without affecting operations d managers can be fired with no effect on ownership e shares must be widely traded 7 in most large corporations ownership and management are separated what are the main implications of this separation 8 what are agency costs and what causes them visit us at www.mhhe.com/bm7e 1 read the following passage companies usually buy a assets these include both tangible assets such as b and intangible assets such as c in order to pay for these assets they sell d assets such as e the decision about which assets to buy is usually termed the f or g decision the decision about how to raise the money is usually termed the h decision now fit each of the following terms into the most appropriate space financing real bonds investment executive airplanes financial capital budgeting brand names quiz

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