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MANAGING PROJECTS

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Projects represent nonroutine business activities that often have long-term strategic ramifications for a firm. In this chapter, we examined how projects differ from routine business activities and discussed the major phases of projects. We noted how environmental changes have resulted in increased attention being paid to projects and project management over the past decade. In the second half of the chapter, we introduced some basic tools that businesses can use when planning for and controlling projects. Both Gantt charts and network diagrams give managers a visual picture of how a project is going. Network diagrams have the added advantage of showing the precedence between activities, as well as the critical path(s). We wrapped up the chapter by showing how these concepts are embedded in inexpensive yet powerful software packages such as Microsoft Project. If you want to learn more about project management, we encourage you to take a look at the Web site for the Proj...
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Mergers and Acquisitions

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This chapter included discussions of mergers, divestitures, and LBOs. The majority of the discussion in this chapter was about mergers. We discussed the rationale for mergers, different types of mergers, the level of merger activity, and merger analysis. We showed how to use two different approaches to value the target firm: discounted cash flow and market multiple analyses. We also explained how the acquiring firm can structure its takeover bid and investment bankers’ roles in arranging and financing mergers. In addition, we discussed two cooperative arrangements that fall short of mergers: corporate, or strategic, alliances and joint ventures.  
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Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles

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While common stock and long-term debt provide most of the capital that corporations use, companies also use several forms of “hybrid securities.” The hybrids include preferred stock, leasing, convertibles, and warrants, each of which has some characteristics of debt and some of equity. We discussed the pros and cons of the hybrids from the standpoints of issuers and investors, the way to determine when to use them, and the factors that affect their values. The basic rationale for these securities and the procedures used to evaluate them are based on concepts developed in earlier chapters.  
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Multinational Financial Management

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Over the past two decades, the global economy has become increasingly integrated and more companies generate more of their profits from overseas operations. In many respects, the concepts developed in the first 18 chapters still apply to multinational firms. However, multinational companies have more opportunities but also face different risks than do companies that operate only in their home market. The chapter discussed many of the key trends affecting the global markets today, and it described the most important differences between multinational and domestic   financial management.  
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Derivatives and Risk Management

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Companies face a variety of risks every day, for it is hard to succeed without taking some chances. In Chapter 8, we discussed the trade-off between risk and return. When some action can lower risk without lowering returns too much, the action can enhance value. Based on that fact, this chapter described the various types of risks that companies face and the basic principles of corporate risk management. One important tool for managing risk is the derivatives market, and this chapter provided an introduction to derivative securities.  
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Financial Planning and Forecasting

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This chapter described techniques for forecasting financial statements, which is a crucial part of the financial planning process. Both investors and corporations regularly use forecasting techniques to help value a company’s stock; to estimate the benefits of potential projects; and to estimate how changes in capital structure, dividend policy, and working capital policy influence shareholder value. The type of forecasting described in this chapter is important for several reasons. First, if the projected operating results are unsatisfactory, management can “go back to the drawing board,” reformulate its plans, and develop more reasonable targets for the coming year. Second, the funds required to meet the sales forecast simply may not be obtainable. If not, it is obviously better to know this in advance and to scale back projected operations than to suddenly run out of cash and have operations grind to an abrupt halt. And third, firms often give guidance to anal...
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Working Capital Management

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This chapter discussed the management of current assets, including cash, marketable securities, inventory, and receivables. Current assets are essential, but there are costs associated with holding them. So if a company can reduce its current assets without hurting sales, this will increase its profitability. The investment in current assets must be financed; and this financing can be in the form of long-term debt, common equity, and/or short-term credit. Firms typically use trade credit and accruals; they also may use bank debt or commercial paper. Although current assets and procedures for financing them can be analyzed as we did in this chapter, decisions are normally made within the context of the firm’s overall financial plan. We take up financial planning in the next chapter; hence, we continue our discussion of working capital there.  
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Distributions to Shareholders: Dividends and Share Repurchases

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Once a company becomes profitable, it must decide what to do with the cash it generates. It may choose to retain cash and use it to purchase additional operating assets, to repay outstanding debt, or to acquire other companies. Alternatively, it may choose to return cash to shareholders. Keep in mind that every dollar that management chooses to retain is a dollar that shareholders could have received and invested elsewhere. Therefore, managers should retain earnings if and only if they can invest the money within the firm and earn more than stockholders can earn outside the firm. Consequently, high growth companies with many good projects tend to retain a high percentage of earnings, whereas mature companies with a great deal of cash but limited investment opportunities tend to have generous cash distribution policies.  
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Capital Structure and Leverage

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When we studied the cost of capital in Chapter 10, we took the firm’s capital structure as given and calculated the cost of capital based on that structure. Then in Chapters 11, 12, and 13, we described capital budgeting techniques, which use the cost of capital as input. Capital budgeting decisions determine the types of projects that a firm accepts, which affect the nature of the firm’s assets and its business risk. In this chapter, we reverse the process, taking the firm’s assets and business risk as given and then seeking to determine the best way to finance those assets. More specifically, in this chapter, we examined the effects of finansial leverage on earnings per share, stock prices, and the cost of capital and we discussed various capital structure theories. The different theories lead to different conclusions about the optimal capital structure, and no one has been able to prove that one theory is better than the others. Therefore, we cannot estimate the ...
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Real Options and Other Topics in Capital Budgeting

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This chapter focused on three aspects of capital budgeting: (1) real options and their effects on projects’ values; (2) the size of the optimal capital budget and the relationship between the budget’s size and the firm’s WACC; and (3) the post-audit, where the results of projects are examined and compared with their forecasted results. We also discussed capital rationing, which occurs when a firm constrains its capital budget in a manner that requires it to reject some projects that have positive NPVs. In the following chapters, we go on to discuss how the target capital structure is established and what effect the capital structure has on the firm’s cost of capital and optimal capital budget. Then we discuss a related topic, dividend policy.  
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Cash Flow Estimation and Risk Analysis

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This chapter focused on estimating the cash flows that are used in a capital budgeting analysis, appraising the riskiness of those flows, finding NPVs when risk is present, and calculating the NPVs of mutually exclusive projects having unequal lives. Here is a summary of our primary conclusions: Some cash flows are relevant (hence, should be included in a capital budgeting analysis), while others should not be included. The key question is this: Is the cash flow incremental in the sense that it will occur if and only if the project is accepted? Sunk costs are not incremental costs—they are not affected by accepting or rejecting the project. Cannibalization and other externalities, on the other hand, are incremental—they will occur if and only if the project is accepted. The cash flows used to analyze a project are different from a project’s net income. One important factor is that depreciation is deducted when accountants calculate net income; but because it is a...
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The Basics of Capital Budgeting

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In this chapter, we described five techniques—NPV, IRR, MIRR, payback, and discounted payback—that are used to evaluate proposed capital budgeting projects. NPV is the best single measure as it tells us how much value each project contributes to shareholder wealth. Therefore, NPV is the method that should be given the greatest weight in decisions. However, the other approaches provide useful information; and in this age of computers, it is easy to calculate all of them. Therefore, managers generally look at all five criteria when deciding to accept or reject projects and when choosing among mutually exclusive projects. In this chapter, we took the cash flows given and used them to illustrate the different capital budgeting methods. As you will see in the next chapter, estimating cash flows is a major task. Still, the framework established in this chapter is critically important for sound capital budgeting analyses; and at this point, you should: -Understand capi...
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The Cost of Capital

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We began this chapter by discussing the concept of the weighted average cost of capital. We then discussed the four capital components (debt, preferred stock, retained earnings, and new common equity) and the procedures used to estimate each component’s cost. Next, we calculated the WACC, which is a key element in capital budgeting. A key issue here is the weights that should be used to find the WACC. In general, companies consider a number of factors, then establish a target capital structure that is used to calculate the WACC. We discuss the target capital structure and its affect on the WACC in more detail in the capital structure chapter. The cost of capital is a key element in capital budgeting decisions, our focus in the following chapters. Indeed, capital budgeting as it should be done is impossible without a good estimate of the cost of capital; so you need to have a good understanding of cost of capital concepts before you move on.  
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Stocks and Their Valuation

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Corporate decisions should be analyzed in terms of how alternative courses of action are likely to affect a firm’s value. However, it is necessary to know how stock prices are established before attempting to measure how a given decision will affect a specific firm’s value. This chapter discussed the rights and privileges of common stockholders, showed how stock values are determined, and explained how investors estimate stocks’ intrinsic values and expected rates of return. Two types of stock valuation models were discussed: the discounted dividend model and the corporate valuation model. The discounted dividend model is useful for mature, stable companies. It is easier to use, but the corporate valuation model is more flexible and better for use with companies that do not pay dividends or whose dividends would be especially hard to predict. We also discussed preferred stock, which is a hybrid security that has some characteristics of a common stock and some of a...
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Risk and Rates of Return

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In this chapter, we described the relationship between risk and return. We discussed how to calculate risk and return for individual assets and for portfolios. In particular, we differentiated between stand-alone risk and risk in a portfolio context and we explained the benefits of diversification. We also discussed the CAPM, which describes how risk should be measured and how risk affects rates of return. In the chapters that follow, we will give you the tools needed to estimate the required rates of return on a firm’s common stock and explain how that return and the yield on its bonds are used to develop the firm’s cost of capital. As you will see, the cost of capital is a key element in the capital budgeting process.  
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Bonds and Their Valuation

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This chapter described the different types of bonds governments and corporations issue, explained how bond prices are established, and discussed how investors estimate rates of return on bonds. It also discussed various types of risks that investors face when they purchase bonds. When an investor purchases a company’s bonds, the investor is providing the company with capital. Moreover, when a firm issues bonds, the return that investors require on the bonds represents the cost of debt capital to the firm. This point is extended in Chapter 10, where the ideas developed in this chapter are used to help determine a company’s overall cost of capital, which is a basic component of the capital budgeting process. In recent years, many companies have used zero coupon bonds to raise billions of dollars, while bankruptcy is an important consideration for companies that issue debt and for investors. Therefore, these two related issues are discussed in detail in Web Appendixes ...
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Interest Rates

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In this chapter, we discussed the way interest rates are determined, the term structure of interest rates, and some of the ways interest rates affect business decisions. We saw that the interest rate on a given bond, r, is based on this equation: r = r * + IP + DRP + LP + MRP Here r* is the real risk-free rate, IP is the premium for expected inflation, DRP is the premium for potential default risk, LP is the premium for lack of liquidity, and MRP is the premium to compensate for the risk inherent in bonds with long maturities. Both r* and the various premiums can and do change over time depending on economic conditions, Federal Reserve actions, and the like. Since changes in these factors are difficult to predict, it is hard to forecast the future direction of interest rates. The yield curve, which relates bonds’ interest rates to their maturities, usually has an upward slope; but it can slope up or down, and both its slope and level change over time. The ma...
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