SKILLS NEEDED FORTHE CHIEF ‘eFINANCE.COM } Chief risk Limiting risk will be even more FINANCIAL OFFICERS OF important as markets become more global and ‘hedging instruments become more complex. xratexist: CFOs will need 10 we realtime Chief communicator: Gaining the confidence of Wall Street lief financial information to make crocial decisions fast. sand the media will be essential Chief deal maker: CFOs must be adept at venture capital, mergers and acquisitions, and strategic partnership. 43 Figure 1.3 Cath Flows between the Firm and the Financial The importance of Cash Flows ‘The most important job of a financial manager is to create value from the firm's ‘apital budgeting, financing, ard net working capital activites. How do financial ‘managers create value? The answer is that the firm should: 1. Try to buy assets that generate more cash than they cost. 2. Sell bonds and stocks and other financial instruments that raise more cash than they cost. ‘Thus. the firm must create more cash flow than it uses. The cash flows paid to bond- holders and stockholders of the firm should be greater than the cash flows put into the fiem by the bondholders and stockhoWers. To see how this is done, we can trace ‘the cash flows from the firm to the financial markets and back again. ‘The interplay of the firm's activities with the financial markets is illustrated in Figure 1.3. The arrows in Figure 1.3 trace eash flow from the firm to the financialCorporate Finance, Tent Eon eS (Chapter 1 intodaction io Corporate Finance ° markets and back again. Suppose we begin with the firm’s financing activities"To raise money, the firm sells debt and equity shares to investors in the financial mar- kets. This results in cash flows from the financial markets to the firm (4). This cash is invested in the investment activities (assets) ofthe firm (B) by the firm's management. ‘The cash generated by the firm (C) is paid to shareholders and bondholders (F). The shareholders reccive cash in the form of dividends: the bondholders who lent funds to the firm receive interest and, when the initial loan is repaid, principal. Not all of the firm's cash is paid our. Some is retained (E), and some is paid to the government as tanes (0). Overtime, if the cash paid to shareholders and bondholders (F) is greater than the cash raised in the financial markets (4), value will be created. Identification of Cash Flows Unfortunately, it is sometimes nat easy to observe cash flows directly. Much of the information we obtain is in the form of ‘accounting statements, and much of the work of financial analysis is to extract cash flow information from accounting statements The following example illustrates how this is done. ‘Accounting Profit versus Cash Flows The Midland Company refines and trades gold. At the ‘dof the year te sold 2.500 ounces of gold for $I milion. The company had acquired the gol for {$900,000 at che beginning ofthe year. The company paid cash for the fol! when k was purchased. Unfortunately has yet to collect from the custome: to whom the gold was sold The fllowing is 4 standard accounting of Midlnd’s francil Greumatances st yearend: Premera sea ee salons a eer eneeri Sales '$1:000,000 a ries By general accepted accounting principles (GAAP).the sale inrecorded even though the customer as yet co pay. assumed that the customer will pay soon. Frem the accountng perspective, Midland seems ro be proftable However, de perspective of corporace fnance is diferent Ie focuses on cath flow: Midland Company eames “The perspective of corporate fnance Is inerested In whether cath lows are being created by the {fd erading operations of Milard. Value creation depends on cash flows. For Midland, vale cre- ‘ation depends on whether and when ie actually recehes $1 milion.Part Overview Timing of Cash Flows The value of an investment made by a firm depends on the timing of cash flows. One of the most important principles of finance is that individuals prefer to receive cash flows earlier rather than later. One dollar received today is worth more than one dollar received next year. ciateav ongeoc lana Gontipuchapiudatioswoue os come Se re ecicae er ree Lp CanmNecason meta foe ae '$ 4000 2 ° . (4.000, 3 ° 4000 ¢ _mn0, an Tu! = $2000 ‘516000 ‘Ac first i appears that new product would be best However the cash flows from proposal 8 come ‘tier than those of A. Without more information, we cannot decide which set of cash lows WOU! create the mort value for the bondholders and shareholders. k depends on whether the value of tong cash from 8 up frone ouewaighs the wx tor cash from A. Bond and stock prices reflect ths ‘reference for earl cath nd we will ee how to ute them to decide between A and B. Risk of Cash Flows ‘The firm must consider risk. The amount and timing ‘of cash flows are not usually known with certainty, Most investors have an aversion torisk. ‘Risk The Midtand Company is considering expanding operations overseas is evaluating Europe and japan as possible sites. Europe it considered to be relatively sale, whereat operating in japan seen a8 very risk. bo cases the company would close down operations after one year ‘After éoirg a complete financial analy. Midland has come up with the folowing cash Hows of ‘the skernavve plans for expanslon under three scenarios pessimistic, Mast lke, and optimistic: EE Jepan 150.000 200,000 we ignore the pessimissc scerario, perhaps Japan is the best alternative. When we tan the pas ‘min scenarto Inco account he choice 1s unclear. Japan appears to be riskier. but it also offers 2 bhigher expected level of cash low. What srak and how can ic be defined? We must try to answer ‘hie important question. Corporate france cannot aveld coping with rtky akernatives, and much of ‘2ur book i devoted to developing methods for eralating risky opportunities.