01 - An Overview of Financial Management

SOURCE: Courtesy BEN & JERRY’S HOMEMADE, INC. www.benjerry.com CHAPTER A n O v e r v i e w o f F i na nc i a l Ma na ge me n t1 make money. For example, in a recent article in Fortune magazine, Alex Taylor III commented that, “Operating a business is tough enough. Once you add social goals to the demands of serving customers, making a profit, and returning value to shareholders, you tie yourself up in knots.” Ben & Jerry’s financial performance has had its ups and downs. While the company’s stock grew by leaps and bounds through the early 1990s, problems began to arise in 1993. These problems included increased competition in the premium ice cream market, along with a leveling off of sales in that market, plus their own inefficiencies and sloppy, haphazard product development strategy. The company lost money for the first time in 1994, and as a result, Ben Cohen stepped down as CEO. Bob Holland, a former consultant for McKinsey & Co. with a reputation as a turnaround specialist, was tapped as Cohen’s replacement. The company’s stock price rebounded in 1995, as the market responded positively to the steps made by Holland to right the company. The stock price, however, floundered toward the end of 1996, following Holland’s resignation. Over the last few years, Ben & Jerry’s has had a new resurgence. Holland’s replacement, Perry Odak, has done a number of things to improve the company’s financial performance, and its reputation among Wall Street’s or many companies, the decision would have been an easy “yes.” However, Ben & Jerry’s Homemade Inc. has always taken pride in doing things differently. Its profits had been declining, but in 1995 the company was offered an opportunity to sell its premium ice cream in the lucrative Japanese market. However, Ben & Jerry’s turned down the business because the Japanese firm that would have distributed their product had failed to develop a reputation for promoting social causes! Robert Holland Jr., Ben & Jerry’s CEO at the time, commented that, “The only reason to take the opportunity was to make money.” Clearly, Holland, who resigned from the company in late 1996, thought there was more to running a business than just making money. The company’s cofounders, Ben Cohen and Jerry Greenfield, opened the first Ben & Jerry’s ice cream shop in 1978 in a vacant Vermont gas station with just $12,000 of capital plus a commitment to run the business in a manner consistent with their underlying values. Even though it is more expensive, the company only buys milk and cream from small local farms in Vermont. In addition, 7.5 percent of the company’s before-tax income is donated to charity, and each of the company’s 750 employees receives three free pints of ice cream each day. Many argue that Ben & Jerry’s philosophy and commitment to social causes compromises its ability to S T R I K I N G T H E R IG H T BA L A N C E BEN & JERRY'S $ F 3 C H A P T E R 1 � A N O V E R V I E W O F F I N A N C I A L M A N AG E M E N T4 The purpose of this chapter is to give you an idea of what financial management is all about. After you finish the chapter, you should have a reasonably good idea of what finance majors might do after graduation. You should also have a better understanding of (1) some of the forces that will affect financial management in the future; (2) the place of finance in a firm’s organization; (3) the relationships between financial managers and their counterparts in the accounting, marketing, production, and personnel departments; (4) the goals of a firm; and (5) the way financial managers can contribute to the attainment of these goals. � C A R E E R O P P O R T U N I T I E S I N F I N A N C E Finance consists of three interrelated areas: (1) money and capital markets, which deals with securities markets and financial institutions; (2) investments, which fo- cuses on the decisions made by both individual and institutional investors as See http:// www.benjerry.com/ mission.html for Ben & Jerry’s interesting mission statement. It might be a good idea to print it out and take it to class for discussion. Information on finance careers, additional chapter links, and practice quizzes are available on the web site to accompany this text: http://www.harcourtcollege. com/finance/concise3e. analysts and institutional investors has benefited. Odak quickly brought in a new management team to rework the company’s production and sales operations, and he aggressively opened new stores and franchises both in the United States and abroad. In April 2000, Ben & Jerry’s took a more dramatic step to benefit its shareholders. It agreed to be acquired by Unilever, a large Anglo-Dutch conglomerate that owns a host of major brands including Dove Soap, Lipton Tea, and Breyers Ice Cream. Unilever agreed to pay $43.60 for each share of Ben & Jerry’s stock—a 66 percent increase over the price the stock traded at just before takeover rumors first surfaced in December 1999. The total price tag for Ben & Jerry’s was $326 million. While the deal clearly benefited Ben & Jerry’s shareholders, some observers believe that the company “sold out” and abandoned its original mission. In response to these concerns, Ben & Jerry’s will retain its Vermont headquarters and its separate board, and its social missions will remain intact. Others have suggested that Ben & Jerry’s philosophy may even induce Unilever to increase its own corporate philanthropy. Despite these assurances, it still remains to be seen whether Ben & Jerry’s vision can be maintained within the confines of a large conglomerate. As you will see throughout the book, many of today’s companies face challenges similar to those of Ben & Jerry’s. Every day, corporations struggle with decisions such as these: Is it fair to our labor force to shift production overseas? What is the appropriate level of compensation for senior management? Should we increase, or decrease, our charitable contributions? In general, how do we balance social concerns against the need to create shareholder value? � 5 they choose securities for their investment portfolios; and (3) financial manage- ment, or “business finance,” which involves decisions within firms. The career opportunities within each field are many and varied, but financial managers must have a knowledge of all three areas if they are to do their jobs well. MONEY AND CAPITAL MARKETS Many finance majors go to work for financial institutions, including banks, in- surance companies, mutual funds, and investment banking firms. For success here, one needs a knowledge of valuation techniques, the factors that cause in- terest rates to rise and fall, the regulations to which financial institutions are subject, and the various types of financial instruments (mortgages, auto loans, certificates of deposit, and so on). One also needs a general knowledge of all as- pects of business administration, because the management of a financial insti- tution involves accounting, marketing, personnel, and computer systems, as well as financial management. An ability to communicate, both orally and in writing, is important, and “people skills,” or the ability to get others to do their jobs well, are critical. INVESTMENTS Finance graduates who go into investments often work for a brokerage house such as Merrill Lynch, either in sales or as a security analyst. Others work for banks, mutual funds, or insurance companies in the management of their in- vestment portfolios; for financial consulting firms advising individual investors or pension funds on how to invest their capital; for investment banks whose pri- mary function is to help businesses raise new capital; or as financial planners whose job is to help individuals develop long-term financial goals and portfolios. The three main functions in the investments area are sales, analyzing individual securities, and determining the optimal mix of securities for a given investor. FINANCIAL MANAGEMENT Financial management is the broadest of the three areas, and the one with the most job opportunities. Financial management is important in all types of busi- nesses, including banks and other financial institutions, as well as industrial and retail firms. Financial management is also important in governmental opera- tions, from schools to hospitals to highway departments. The job opportunities in financial management range from making decisions regarding plant expan- sions to choosing what types of securities to issue when financing expansion. Financial managers also have the responsibility for deciding the credit terms under which customers may buy, how much inventory the firm should carry, how much cash to keep on hand, whether to acquire other firms (merger analy- sis), and how much of the firm’s earnings to plow back into the business versus pay out as dividends. Regardless of which area a finance major enters, he or she will need a knowl- edge of all three areas. For example, a bank lending officer cannot do his or her C A R E E R O P P O R T U N I T I E S I N F I N A N C E Consult http:// www.careers-in- business.com for an excellent site containing information on a variety of business career areas, listings of current jobs, and a variety of other reference materials. C H A P T E R 1 � A N O V E R V I E W O F F I N A N C I A L M A N AG E M E N T6 SELF-TEST QUESTIONS What are the three main areas of finance? If you have definite plans to go into one area, why is it necessary that you know something about the other areas? Why is it necessary for business students who do not plan to major in fi- nance to understand the basics of finance? job well without a good understanding of financial management, because he or she must be able to judge how well a business is being operated. The same thing holds true for Merrill Lynch’s security analysts and stockbrokers, who must have an understanding of general financial principles if they are to give their cus- tomers intelligent advice. Similarly, corporate financial managers need to know what their bankers are thinking about, and they also need to know how investors judge a firm’s performance and thus determine its stock price. So, if you decide to make finance your career, you will need to know something about all three areas. But suppose you do not plan to major in finance. Is the subject still important to you? Absolutely, for two reasons: (1) You need a knowledge of finance to make many personal decisions, ranging from investing for your retirement to decid- ing whether to lease versus buy a car. (2) Virtually all important business deci- sions have financial implications, so important decisions are generally made by teams from the accounting, finance, legal, marketing, personnel, and production departments. Therefore, if you want to succeed in the business arena, you must be highly competent in your own area, say, marketing, but you must also have a familiarity with the other business disciplines, including finance. Thus, there are financial implications in virtually all business decisions, and nonfi- nancial executives simply must know enough finance to work these implications into their own specialized analyses.1 Because of this, every student of business, regard- less of his or her major, should be concerned with financial management. 1 It is an interesting fact that the course “Financial Management for Nonfinancial Executives” has the highest enrollment in most executive development programs. F I N A N C I A L M A N AG E M E N T I N T H E N E W M I L L E N N I U M When financial management emerged as a separate field of study in the early 1900s, the emphasis was on the legal aspects of mergers, the formation of new firms, and the various types of securities firms could issue to raise capital. Dur- ing the Depression of the 1930s, the emphasis shifted to bankruptcy and reor- ganization, corporate liquidity, and the regulation of security markets. During the 1940s and early 1950s, finance continued to be taught as a descriptive, in- stitutional subject, viewed more from the standpoint of an outsider rather than that of a manager. However, a movement toward theoretical analysis began during the late 1950s, and the focus shifted to managerial decisions designed to maximize the value of the firm. 7 The focus on value maximization continues as we begin the 21st century. However, two other trends are becoming increasingly important: (1) the glob- alization of business and (2) the increased use of information technology. Both of these trends provide companies with exciting new opportunities to increase profitability and reduce risks. However, these trends are also leading to in- creased competition and new risks. To emphasize these points throughout the book, we regularly profile how companies or industries have been affected by increased globalization and changing technology. These profiles are found in the boxes labeled “Global Perspectives” and “Technology Matters.” GLOBALIZAT ION OF BUSINESS Many companies today rely to a large and increasing extent on overseas opera- tions. Table 1-1 summarizes the percentage of overseas revenues and profits for 10 well-known corporations. Very clearly, these 10 “American” companies are really international concerns. Four factors have led to the increased globalization of businesses: (1) Im- provements in transportation and communications lowered shipping costs and made international trade more feasible. (2) The increasing political clout of consumers, who desire low-cost, high-quality products. This has helped lower trade barriers designed to protect inefficient, high-cost domestic manufacturers and their workers. (3) As technology has become more advanced, the costs of developing new products have increased. These rising costs have led to joint ventures between such companies as General Motors and Toyota, and to global operations for many firms as they seek to expand markets and thus spread development costs over higher unit sales. (4) In a world populated with multi- national firms able to shift production to wherever costs are lowest, a firm whose manufacturing operations are restricted to one country cannot compete unless costs in its home country happen to be low, a condition that does not F I N A N C I A L M A N AG E M E N T I N T H E N E W M I L L E N N I U M T A B L E 1 - 1 PERCENTAGE OF REVENUE PERCENTAGE OF NET INCOME COMPANY ORIGINATED OVERSEAS GENERATED OVERSEAS Chase Manhattan 23.9 21.9 Coca-Cola 61.2 65.1 Exxon Mobil 71.8 62.7 General Electric 31.7 22.8 General Motors 26.3 55.3 IBM 57.5 49.6 McDonald’s 61.6 60.9 Merck 21.6 43.4 Minn. Mining & Mfg. 52.1 27.2 Walt Disney 15.4 16.6 SOURCE: Forbes Magazine’s 1999 Ranking of the 100 Largest U.S. Multinationals; Forbes, July 24, 2000, 335–338. Percentage of Revenue and Net Income from Overseas Operations for 10 Well-Known Corporations Check out http:// www.nummi.com/ home.htm to find out more about New United Motor Manufacturing, Inc. (NUMMI), the joint venture between Toyota and General Motors. Read about NUMMI’s history and organizational goals. C H A P T E R 1 � A N O V E R V I E W O F F I N A N C I A L M A N AG E M E N T8 necessarily exist for many U.S. corporations. As a result of these four factors, survival requires that most manufacturers produce and sell globally. Service companies, including banks, advertising agencies, and accounting firms, are also being forced to “go global,” because these firms can best serve their multinational clients if they have worldwide operations. There will, of course, al- ways be some purely domestic companies, but the most dynamic growth, and the best employment opportunities, are often with companies that operate worldwide. Even businesses that operate exclusively in the United States are not immune to the effects of globalization. For example, the costs to a homebuilder in rural Nebraska are affected by interest rates and lumber prices — both of which are de- termined by worldwide supply and demand conditions. Furthermore, demand for the homebuilder’s houses is influenced by interest rates and also by conditions in the local farm economy, which depend to a large extent on foreign demand for wheat. To operate efficiently, the Nebraska builder must be able to forecast the de- mand for houses, and that demand depends on worldwide events. So, at least some knowledge of global economic conditions is important to virtually everyone, not just to those involved with businesses that operate internationally. INFORMATION TECHNOLOGY As we advance into the new millennium, we will see continued advances in com- puter and communications technology, and this will continue to revolutionize the way financial decisions are made. Companies are linking networks of personal During the past 20 years, Coca-Cola has createdtremendous value for its shareholders. A $10,000 investment in Coke stock in January 1980 would have grown to nearly $600,000 by mid-1998. A large part of that im- pressive growth was due to Coke’s overseas expansion program. Today nearly 75 percent of Coke’s profit comes from overseas, and Coke sells roughly half of the world’s soft drinks. More recently, Coke has discovered that there are also risks when investing overseas. Indeed, between mid-1998 and Janu- ary 2001, Coke’s stock fell by roughtly a third—which means that the $600,000 stock investment decreased in value to $400,000 in about 2.5 years. Coke’s poor performance during this period was due in large part to troubles overseas. Weak economic conditions in Brazil, Germany, Japan, Southeast Asia, Venezuela, Colombia, and Russia, plus a quality scare in Bel- gium and France, hurt the company’s bottom line. Despite its recent difficulties, Coke remains committed to its global vision. Coke is also striving to learn from these difficul- ties. The company’s leaders have acknowledged that Coke may have become overly centralized. Centralized control enabled Coke to standardize quality and to capture operating efficiencies, both of which initially helped to establish its brand name throughout the world. More recently, however, Coke has become concerned that too much centralized control has made it slow to respond to changing circumstances and insensitive to differences among the various local markets it serves. Coke’s CEO, Douglas N. Daft, reflected these concerns in a re- cent editorial that was published in the March 27, 2000, edi- tion of Financial Times. Daft’s concluding comments appear below: So overall, we will draw on a long-standing belief that Coca- Cola always flourishes when our people are allowed to use their insight to build the business in ways best suited to their local culture and business conditions. We will, of course, maintain clear order. Our small corpo- rate team will communicate explicitly the clear strategy, pol- icy, values, and quality standards needed to keep us cohe- sive and efficient. But just as important, we will also make sure we stay out of the way of our local people and let them do their jobs. That will enhance significantly our ability to unlock growth opportunities, which will enable us to consis- tently meet our growth expectations. In our recent past, we succeeded because we understood and appealed to global commonalties. In our future, we’ll succeed because we will also understand and appeal to local differences. The 21st century demands nothing less. COKE RIDES THE GLOBAL ECONOMY WAVE For more information about the Coca-Cola Company, go to http://www.thecoca- colacompany.com/world/ index.html, where you can find profiles of Coca-Cola’s presence in foreign countries. You may follow additional links to Coca-Cola web sites in foreign countries. 9F I N A N C I A L M A N AG E M E N T I N T H E N E W M I L L E N N I U M eTOYS TAKES ON TOYS “ ” USR The toy market illustrates how electronic commerce is chang-ing the way firms o