Etextbook PDF For Business Finance 1st Australian by Robert Parrino

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PARRINO | KIDWELL | AU YONG | DEMPSEY | MORKEL-KINGSBURY | EKANAYAKE | JAMES | MURRAY
BUSINESS FINANCE FIRST EDITION

The importance of capital budgeting 257 Incremental after-tax free cash flows 304
The capital budgeting process 257 The FCF calculation 305
Sources of information 258 Cash flows from operations 306
Classification of investment projects 259 Cash flows associated with investments 307
Basic capital budgeting terms 259 The FCF calculation: an example 307
8.2 Net present value 260 9.2 Estimating cash flows in practice 312
Valuation of real assets 260 Five general rules for incremental after-tax free
NPV — the basic concept 261 cash flow calculations 312
NPV and value creation 261 Nominal versus real cash flows 315
Framework for calculating NPV 262 Tax rates and depreciation 318
Net present value technique 264 Calculating the terminal-year FCF 319
Concluding comments on NPV 268 Expected cash flows 321
8.3 The payback period 269 9.3 Projects with different lives 322
Calculating the payback period 269 9.4 When to harvest an asset 326
How the payback period performs 271 When to replace an existing asset 327
Discounted payback period 272 The cost of using an existing asset 328
Evaluating the payback rule 273
8.4 The accounting rate of return 274 Summary of learning objectives 330
8.5 Internal rate of return 274 Key terms 331
Calculating the IRR 275 Summary of key equations 331
When the IRR and NPV methods agree — Self-study problems 332
independent projects and conventional cash Critical thinking questions 332
flows 278 Questions and problems 333
When the IRR and NPV methods disagree — Endnotes 337
mutually exclusive projects and unconventional Acknowledgements 337
cash flows 279
Modified internal rate of return (MIRR) 284 CHAPTER 10
IRR versus NPV: a final comment 285
8.6 Capital budgeting in practice 286
Evaluating project
Practitioners’ methods of choice 286 economics and capital
Ongoing and postaudit reviews 287 rationing 338
Chapter preview 339
Summary of learning objectives 288 10.1 Variable costs, fixed costs and project
Key terms 289 risk 340
Summary of key equations 289
Cost structure and sensitivity of EBITDA to
Self-study problems 290
revenue changes 341
Critical thinking questions 290
Cost structure and sensitivity of EBIT to revenue
Questions and problems 291
changes 344
Appendix: An example using a financial calculator for
capital budgeting calculations 297 10.2 Calculating operating leverage 347
Endnotes 299 Degree of pre-tax cash flow operating
Acknowledgements 300 leverage 347
Degree of accounting operating leverage 348
CHAPTER 9 10.3 Break-even analysis 350
Pre-tax operating cash flow break-even 350
Cash flows and capital Accounting break-even 352
budgeting 301 10.4 Risk analysis 355
Chapter preview 303 Sensitivity analysis 356
9.1 Calculating project cash flows 303 Scenario analysis 356
Cash flow versus accounting Simulation analysis 357
earnings 304 Decision tree analysis 358
CONTENTS vi
10.5 Investment decisions with capital CHAPTER 12
rationing 359
Capital rationing in a single period 359 Working capital
Capital rationing across multiple periods 362 management 408
Chapter preview 410
Summary of learning objectives 363 12.1 Working capital basics 410
Key terms 364 Working capital terms and concepts 410
Summary of key equations 364
Working capital accounts and trade-offs 412
12.2 The operating and cash conversion
cycles 413
Endnotes 369 Operating cycle 414
Acknowledgements 369 Cash conversion cycle 416
12.3 Working capital management strategies 418
CHAPTER 11 Flexible current asset management strategy 419
Restrictive current asset management
The cost of capital 370 strategy 419
Chapter preview 372 The working capital trade-off 419
11.1 The company’s overall cost of capital 372 12.4 Accounts receivable 420
The finance balance sheet 373 Terms of sale 420
How companies estimate their cost of capital 375 Ageing accounts receivable 422
11.2 The cost of debt 377 12.5 Inventory management 423
Key concepts for estimating the cost of debt 377 Economic order quantity 423
Estimating the current cost of a bond or an Just-in-time inventory management 425
outstanding loan 378 12.6 Cash management and budgeting 425
Tax and the cost of debt 380 Reasons for holding cash 425
Estimating the cost of debt for a company 380 Cash collection 426
11.3 The cost of equity 383 12.7 Financing working capital 427
Ordinary shares 383 Strategies for financing working capital 427
Preference shares 389 Financing working capital in practice 429
11.4 Using the WACC in practice 391 Sources of short-term financing 429
Calculating WACC: an example 392
Limitations of WACC as a discount rate for Summary of learning objectives 433
evaluating projects 394 Key terms 434
Alternatives to using WACC for evaluating Summary of key equations 435
projects 397 Self-study problems 435
Consistency of the WACC and Dividend Discount Critical thinking questions 435
Models 399 Questions and problems 436
Endnotes 440
Summary of learning objectives 400 Acknowledgements 440
Key terms 400
Summary of key equations 401 CHAPTER 13
Critical thinking questions 401 How companies raise
Questions and problems 402 capital 441
Sample test problems 405
Chapter preview 442
Endnotes 405
Acknowledgements 406 13.1 Bootstrapping 443
How new businesses get started 443
PART 4 Initial funding of the company 443
13.2 Venture capital 444
Working capital management The venture capital industry 444
and financing decisions 407 Why venture capital funding is different 444
vii CONTENTS
The venture capital funding cycle 445 14.4 Practical considerations in choosing a
The cost of venture capital funding 448 capital structure 496
13.3 Initial public offering 449
Advantages and disadvantages of going Summary of learning objectives 498
public 449 Key terms 499
Investment banking services 450 Summary of key equations 499
Origination 451
Underwriting 451
The proceeds 453 Endnotes 504
13.4 IPO pricing and cost 454 Acknowledgements 504
The underpricing debate 454
IPOs are consistently underpriced 455 CHAPTER 15
The cost of an IPO 456
13.5 Open offers by a public company 457 Dividends and dividend
The cost of an open public offer 458 policy 505
13.6 Private markets and bank loans 458 Chapter preview 506
Private versus public markets 458 15.1 Dividends 507
Private placements 459 Types of dividends 507
Private equity companies 459 Dividends and taxation 508
13.7 Commercial bank lending 460 The dividend payment process 509
Business overdraft 461 15.2 Share buy-backs 512
Bank term loans 461 How share buy-backs differ from dividends 512
The loan pricing model 461 How a share buy-back happens 513
Concluding comments on funding the 15.3 Dividend policy and company value 514
company 463 Benefits and costs of dividends 515
Share price reactions to dividend
Summary of learning objectives 464 announcements 517
Key terms 465 Dividends versus share buy-backs 518
Summary of key equation 465 15.4 Bonus share issues and share splits 519
Self-study problems 465 Bonus share issues 519
Share splits 520
Reasons for bonus share issues and splits 520
Endnotes 468
15.5 Setting a dividend policy 521
Acknowledgements 468
What managers tell us 521
CHAPTER 14 Practical considerations in setting a dividend
policy 521
Capital structure policy 469
Chapter preview 471 Summary of learning objectives 523
14.1 Capital structure and company value 471 Key terms 524
The optimal capital structure 471 Self-study problems 524
The Modigliani and Miller propositions 472
14.2 The benefits and costs of using debt 481
Endnotes 527
The benefits of debt 481 Acknowledgements 527
The costs of debt 488
14.3 Two theories of capital structure 494 APPENDIX
The trade-off theory 494
The pecking order theory 494 Present value and future value
The empirical evidence 495 tables 528
CONTENTS viii
ABOUT THE AUTHORS
Robert Parrino is the Lamar Savings Centennial Professor of Finance in the McCombs School of Busi-
ness, University of Texas at Austin. He is the Associate Editor of Journal of Corporate Finance and
Journal of Financial Research. He has experience in the application of corporate finance concepts in a
variety of business situations and researches on corporate governance, financial policies, restructuring,
mergers and acquisitions, and private equity markets.
David S. Kidwell is Professor of Finance and Dean Emeritus at the Curtis L. Carlson School of Man-
agement, University of Minnesota. He has over 30 years’ experience in financial education, as a teacher,
researcher and administrator. He has published in leading journals such as Journal of Finance, Journal
of Financial Economics, Journal of Financial and Quantitative Analysis, Financial Management and
Journal of Money, Credit and Banking.
Hue Hwa Au Yong is a Senior Lecturer in the Department of Accounting and Finance at Monash Uni-
versity. Prior to this, she completed her PhD in the area of risk management at Monash University.
Her research has been published in several international peer reviewed journals, including Journal
of International Financial Markets, Institutions and Money; Australian Journal of Management; and
International Review of Financial Analysis. She specialises in teaching corporate finance. In 2009, she
was awarded the Faculty of Business and Economics Dean’s Commendation for Outstanding Teaching.
Michael Dempsey is a Professor of Finance in the Department of Economics, Finance and Marketing at
RMIT University. Prior to this, he was with Monash University and Griffith University, having previ-
ously been at Leeds University, United Kingdom. He also has many years’ experience working for the
petroleum exploration industry in the Middle East, Aberdeen and London. His PhD was obtained in
Astrophysics. His teaching responsibilities have been in corporate and investment finance, international
finance, derivatives and financial engineering. He is an active researcher and research supervisor in the
area of financial markets and the formation of asset prices, where he has continued to publish as well as
referee major journal articles.
Samson Ekanayake is a Senior Lecturer in finance at Deakin University. He has been teaching busi-
ness and corporate finance at Deakin since 1992 and also served as the Discipline Leader for Finance
until July 2010. Samson has won several awards for teaching excellence in business finance and was
nominated for Faculty Awards for innovative teaching in 2010. His research interests include corporate
finance, management control and enterprise risk management. Before joining Deakin University, he held
senior managerial positions in accounting and finance in several reputed companies. To name a few,
he was the Finance Manager of Mitsubishi Olayan Machinery Industries, Corporate Treasurer of The
Finance Company, and Economist of Fiji Sugar Corporation. Samson is a Chartered Accountant and a
Certified Practising Accountant. He completed his postgraduate studies at the University of Lancaster in
England.
Jennifer James was formerly a Lecturer in the School of Business and Law at Central Queensland
University. She has over 12 years teaching experience and specialises in teaching corporate finance and
auditing and professional practice. In 2008, she was awarded the Faculty of Business and Informatics
Award for Teaching Excellence and Central Queensland University’s Innovative Teacher of the Year
Award. Jenny was awarded an ALTC Citation for Outstanding Contributions to Student Learning in
2009. Her research interests focus on improving her teaching strategies to maximise student learning.
In 2009, she was awarded an Outstanding Paper Award at the World Conference on Educational Media
and Technology in Honolulu and the Edith Cowan Authentic Learning Award at the Higher Education
Research and Development Society of Australasia Conference in Darwin.
Nigel Morkel-Kingsbury is a Lecturer in the Department of Banking and Finance at Monash Univer-
sity. He is an experienced educator at both graduate and undergraduate levels, specialising in teaching
corporate finance and international study programs. His research interests and publications include the
following areas: central bank transparency and interest rates (the topic of his doctoral thesis), monetary
policy, corporate finance and initial public offerings.
James Murray previously taught at Monash University, and has also tutored at Swinburne University
of Technology and Lincoln University. He completed his PhD in the area of dividend policy at Monash
University. His research interests primarily relate to the role of the legal and tax environment in cor-
porate finance.
ABOUT THE AUTHORS x

PREFACE
Business finance, 1st edition, has been developed for use in an introductory course in finance.
Balance between conceptual understanding and

computational skills
Business finance reflects the reality that finance, as an intellectual discipline, continues to be challenged
by the experiences and events of market activity. Since the global financial crisis, managers have faced
uncertain times. Thus, although the teaching of finance may have remained robust as a framework of
conceptual thought, it is imperative that students come to realise that ‘finance is not physics’, by which
we mean that even a concept as foundational to financial management as the capital asset pricing model
(CAPM) should not be interpreted as a literal truth. This leads to a consideration of managing risk and
risk management approaches as having behavioural aspects that are the outcomes of a manager’s or the
firm’s accumulated experience. They cannot always be reduced to the simple directives of a quantitative
algorithm.
Our primary objective in writing this text was to provide students and lecturers with a book that
strikes the best possible balance between helping students develop an intuitive understanding of key
financial concepts and providing them with problem-solving and decision-making skills. In our experi-
ence, teaching students at all levels, we have found that students who understand the intuition under-
lying the basic concepts of finance are better able to develop the critical judgement necessary to apply
financial tools to a broad range of real-world situations. An introductory corporate finance course should
provide students with a strong understanding of both the concepts and tools that will help them in their
subsequent business studies and personal and professional lives.
Market research supports our view. Academics who teach the introductory corporate finance course
to undergraduates express a desire for a resource that bridges the gap between conceptually focused
and computationally focused. This text is designed to bridge this gap. Specifically, the text develops the
fundamental concepts underlying corporate finance in an intuitive manner while maintaining a strong
emphasis on developing computational skills. It also takes the students one step further by emphasising
the use of intuition and analytical skills in decision making.
Our ultimate goal has been to write a resource and develop associated learning tools that help our
colleagues succeed in the classroom — materials that are genuinely helpful in the learning process. Our
resource offers a level of rigour that is appropriate for finance majors and yet presents the content in a
manner that both finance and non-finance students find accessible and want to read. Writing a resource
that is both rigorous and accessible has therefore been one of our key objectives. We have also tried to
provide solutions to many of the challenges facing academics in the current environment, academics
who are asked to teach ever-increasing numbers of students with limited resources. Finance academics
need a resource and associated learning tools that help them effectively leverage their time. The organ-
isation of this resource and the supplementary materials provide such leverage to an extent not found
with other textbooks.
A focus on value creation

This resource is more than a collection of ideas, equations and chapters. It has an important integrating
theme — that of value creation. This theme, which is carried throughout the resource, provides a frame-
work that helps students understand the relations between the various concepts covered in the resource
and makes it easier for them to learn these concepts.
The concept of value creation is the most fundamental notion in corporate finance. It is in share-
holders’ best interests for value maximisation to be at the heart of the financial decisions made within
the company. Thus, it is critical that students be able to analyse and make business decisions with a
focus on value creation. The concept of value creation is introduced in the first chapter and is further
developed and applied throughout the remaining chapters.
The theme of value creation is operationalised through the net present value (NPV) concept. Once
students grasp the fundamental idea that financial decision makers should choose only courses of action
whose benefits exceed their costs, analysis and decision making, using NPV becomes common sense.
By helping students better understand the economic rationale for a decision from the outset, rather than
initially focusing on computational skills, our text helps students remain focused on the true purpose of
the calculations and the decision at hand.
Integrated approach: intuition, analysis and decision making

To support the focus on value creation, we have emphasised three approaches: (1) providing an intuitive
framework for understanding fundamental finance concepts, (2) teaching students how to analyse and
solve finance problems and (3) helping students develop the ability to use the results from their analyses
to make good financial decisions.
1. An intuitive approach. We believe that explaining finance concepts in an intuitive context helps
students develop a richer understanding of those concepts and gain better insights into how finance
problems can be approached. It is our experience that students who have a strong conceptual under-
standing of finance theory better understand how things really work and are better problem solvers
and decision makers than students who focus primarily on computational skills.
2. Analysis and problem solving. With a strong understanding of the basic principles of finance, stu-
dents are equipped to tackle a wide range of financial problems. In addition to the many numerical
examples that are solved in the text of each chapter, this book has more than 1000 end-of-chapter
homework and review problems that have been written with Bloom’s Taxonomy in mind. We strive to
help students acquire the ability to analyse and solve finance problems.
3. Decision making. In the end, we want to prepare students to make sound financial decisions. To help
students develop these skills, throughout the text we illustrate how the results from financial analyses
are used in decision making.
Robert Parrino
David S. Kidwell
Hue Hwa Au Yong
Michael Dempsey
Samson Ekanayake
Jennifer James
Nigel Morkel-Kingsbury
James Murray
May 2016
PREFACE xii
ORGANISATION
AND COVERAGE
In order to help students develop the skills necessary to tackle investment and financing decisions, we
have arranged the 15 chapters into major building blocks that collectively comprise the four parts of the
resource, as described below.
Introduction
Part 1, which consists of chapters 1 and 2, provides an introduction to corporate finance and the financial
environment. Chapter 1 describes the role of the financial manager, the types of fundamental decisions
that financial managers make, alternative forms of business organisation, the goal of the company,
agency problems and how they arise, and the importance of ethics in financial decision making. These
discussions set the stage and provide a framework that students can use to think about key concepts as
the course progresses. Chapter 2 explains the services financial institutions provide to new businesses,
how domestic and international financial markets work, how firms use financial markets, and how the
level of interest rates in the economy is determined.
Basic concepts and tools

Part 2 presents basic financial concepts and tools and illustrates their application. This part of the text,
which consists of chapters 3 to 7, introduces the time value of money and risk and return concepts and
extends them to cover the principles underlying the application of present value concepts to bond and
share valuation. These chapters provide students with basic financial intuition and computational tools that
will serve as the building blocks for analysing investment and financing decisions in subsequent chapters.
Analysis
Parts 3 and 4 of the text focus on investment and financing decisions. Part 3 covers capital budgeting.
Chapter 8 introduces the concept of net present value and illustrates its application. This discussion
provides a framework that will help students in the rest of part 3 as they learn the nuances of capital
budgeting analysis in realistic settings.
Chapters 9 and 10 follow with in-depth discussions of how cash flows are calculated and forecast. The
cash flow calculations are presented in chapter 9 using a valuation framework that will help students think
about valuation concepts in an intuitive way. Chapter 10 covers analytical tools — such as break-even, sensi-
tivity, scenario and simulation analysis — that will give students a better appreciation for how they can deal
with the uncertainties associated with cash flow forecasts. Capital rationing is also covered in chapter 10.
Chapter 11 explains how the discount rates used in capital budgeting are estimated. This chapter
uses an innovative concept — that of the finance balance sheet — to help students develop an intuitive
understanding of the relationships between the costs of the individual components of capital and the
company’s overall weighted average cost of capital. It also provides a detailed discussion of methods
used to estimate the costs of the individual components of capital that are used to finance a company’s
investments and how these estimates are used in capital budgeting.
Part 4 covers working capital management and financing decisions. It begins, in chapter 12, with
a discussion of how companies manage their working capital and the implications of working capital
management decisions for financing decisions and company value. This discussion is followed, in
chapters 13 and 14, with discussions of how companies raise capital to fund their real activities and
what factors affect how firms choose among the various sources of capital available to them. Chapter 15
rounds out the discussion of financing decisions with an introduction to dividends and dividend policy.
APPLICATIONS AT
A GLANCE
The real-world examples in Business finance, 1st edition, have been carefully chosen to include a bal-
ance of organisations operating in our region representing a diverse range of relevant product and service
industries.
1 The financial manager and the company

a2 Milk Company Reviews the reasons managers create company value and finance a company
either through debt or equity. Focuses on the value created by a2 Milk’s market
capitalisation.
2 The financial environment and the level of interest rates

The Reserve Bank Discusses how the Reserve Bank of Australia manages monetary policy and the
of Australia implications this has for economic activity.
3 The time value of money

Harvey Norman and Provides glimpses into the different financing options about which retail
The Good Guys consumers must make decisions every day, including the analysis of expected
cash flows.
4 Discounted cash flows and valuation

Superannuation in Australia Discusses the importance of planning for retirement, ensuring the compounding
of multiple cash flows.
5 Risk and return

Xero and Woolworths Technology companies are currently experiencing high growth, but this comes
with increased risk. The returns of Xero are compared against blue chip food
retailer, Woolworths.
6 Bond valuation and the structure of interest rates

The European Union The Greek sovereign debt crisis has highlighted the major risk faced by
debt crisis bondholders — the risk of default.
7 Share valuation
Rise and fall of share prices Investigates the ASX All Ordinaries Index and raises the question: how can one
tell if the market price of a share reflects its value?
8 The fundamentals of capital budgeting

BHP Billiton Reveals some of the capital budgeting decisions BHP Billiton has made in
recent years to maintain its competitive advantage.
9 Cash flows and capital budgeting

Justine’s Limited Capital budgeting decisions and cash flows are important for an expanding
business such as Justine’s Limited. These concepts would be employed as it
purchases new equipment.
10 Evaluating project economics and capital rationing

The mining industry Mining is an industry in which project analysis is crucial in evaluating the
appropriate level of capital investment.
11 The cost of capital
Q1 Tower, Gold Coast How does one estimate what it would cost to finance a project such as the Q1
Tower? This example initiates the discussion on how to take account of the cost
of capital in financing decisions.
12 Working capital management

Whitehaven Coal Limited In an environment of increasing expansion of its coal mines, Whitehaven Coal
Limited found it was important to effectively manage its working capital.
13 How companies raise capital

Amaysim Australian Limited Describes how amaysim raised capital through an initial public offering.
14 Capital structure policy

PKF — chartered accountants Discusses why it is vital that companies have the right capital structure mix for
and business advisers their business.
15 Dividends and dividend policy

BHP Billiton Examines the recent dividends paid out by BHP Billiton.
xv APPLICATIONS AT A GLANCE
HOW TO USE THIS
RESOURCE
Business finance, 1st edition, has been designed with you — the student — in mind. The design is our
attempt to provide you with a resource that both communicates the subject matter and will facilitate
learning. We have tried to accomplish these goals through the following elements.
Chapter scene setter

Each chapter begins with a vignette that describes a real company application. The vignettes illus-
trate concepts that will be presented in the chapter and are meant to heighten student interest, motivate
learning and demonstrate the real-life relevance of the material in the chapter.
chapter 12
Working capital
management
Le ar ni ng Ob je ct i v e s Learning objectives The opening
After studying this chapter, you should be able to:
12.1 define and calculate net working capital and discuss the importance of working capital management
vignette is accompanied by learning
12.2 define the operating and cash conversion cycles, explain their use, and calculate their values
12.3 discuss the relative advantages and disadvantages of pursuing (1) flexible and (2) restrictive current objectives that identify the most
asset management strategies
12.4 explain how accounts receivable are created and managed, and calculate the cost of trade credit
12.5 explain the trade-off between carrying costs and reorder costs, and calculate the economic order
important material for students to
quantity for inventory
12.6 define cash collection time and discuss how a company can minimise this time understand while reading the chapter. A
12.7 identify three current asset financing strategies and discuss the main sources of short-term financing.
summary of learning objectives appears
at the end of the chapter.
Key pOINt
high fixed costs mean larger fluctuations in cash flows and profits
The higher the proportion of fixed costs to variable costs in a project, the more pre-tax operating cash
flows (EBITDA) and accounting operating profits (EBIT) will vary as revenue varies. This is true because it
is more difficult to change fixed costs than to change variable costs when unit sales change. If unit sales
decline, EBITDA and EBIT will drop more in a business where fixed costs represent a larger proportion
of total costs. Conversely, if unit sales increase, EBITDA and EBIT will increase more in a business with
higher fixed costs.
demONstratION prOBLem 10.1
forecasting eBIt
problem
You have decided to start a business that pro-
vides in-home technical computer support to
c12WorkingCapitalManagement 408 15 December 2015 7:20 PM people in the suburb near your university. You
have seen national advertisements for a com-
pany that provides these services in other sub-
urbs. You would run this business out of your
room, and you know plenty of students who
have the necessary technical skills and would
Demonstration problem Along with a

welcome the opportunity to earn some pocket
money. To get up and running quickly, you
would have to invest in a computer system, an
generous number of in-text examples, most advertising campaign, three vehicles and tools.
You would also want to have enough cash to
keep the business going until it began to gen-
chapters include several demonstration erate positive cash flows. All of this would require about $100 000, which is about all that you think you
can borrow on your credit cards, against your car, and from friends and family.
You are now working on the financial forecasts for the business. You plan to charge $45 for house
problems. These demonstrations contain calls lasting up to 30 minutes and $25 for each additional 30 minutes. Since you expect that the typical
house call will require 60 minutes, you expect it to result in revenue of $70. You also estimate that
quantitative problems with step-by-step

monthly fixed operating costs (FC) which include an advertising contract with a local radio station and
a small salary for you, will total $3000. Unit VC, including the technicians’ pay, petrol and so forth, will
total $20 for the typical house call. Monthly depreciation and amortisation charges (D&A) will be $1000.
solutions to help students better understand

Finally, you expect that after 6 months the business will average 120 house calls per month. Given this
information, what do you expect the monthly EBIT to be in 6 months?
approach
how to apply their intuition and analytical Since EBIT = Revenue - VC - FC - D&A (see, for example, figure 10.5), you can forecast the expected
monthly EBIT in 6 months by using this equation and the values for Revenue, VC, FC and D&A that you
skills to solve important problems. By

expect in 6 months.
solution
The calculation is as follows:
including these exercises, we provide Revenue $70 per house call × 120 calls $8400
students with additional practice in the

- VC $20 per house call × 120 calls 2400
- FC 3000
- D&A 1000
application of the concepts, tools and EBIT $2000
methods that are discussed in the text. Chapter 10 Evaluating project economics and capital rationing 345
c10EvaluatingProjectEconomicsAndCapitalRationing 345 14 December 2015 6:19 PM

Key pOINt
high fixed costs mean larger fluctuations in cash flows and profits
The higher the proportion of fixed costs to variable costs in a project, the more pre-tax operating cash
flows (EBITDA) and accounting operating profits (EBIT) will vary as revenue varies. This is true because it
is more difficult to change fixed costs than to change variable costs when unit sales change. If unit sales
decline, EBITDA and EBIT will drop more in a business where fixed costs represent a larger proportion
of total costs. Conversely, if unit sales increase, EBITDA and EBIT will increase more in a business with
higher fixed costs.
demONstratION prOBLem 10.1

Key point Students must have an intuitive understanding of a number of important principles and
forecasting eBIt
concepts to successfully
problem master the finance curriculum. We emphasise these important concepts
by presenting them in key point boxes. These boxes provide a statement of an important finance
You have decided to start a business that pro-
approach
Use the four-step procedure presented in the text to determine which projects you should accept.
vides in-home technical computer support to
concept, such as the relationship between risk and expected returns, along with an intuitive example
solution
people in the suburb near your university. You
Calculating the PI and ranking the projects from highest to lowest PI yields the following:
have seen national advertisements for a com-
or explanation topanyhelp thethese
student
services in ‘get’
other sub-the concept. These boxes help the students develop finance
Project Investment NPV @10% PI
that provides Buy new tool set $ 500 $1 000 $1 500/$500 = 3.000
urbs. You would run this business out of your
Buy employee training program 8 000 4 000 $12 000/$8 000 = 1.500
intuition. Collectively
room, and the key point boxeswho cover the most important concepts in corporate finance.
= 1.500
Paint existing cars 4 000 2 000 $6 000/$4 000
you know plenty of students
Buy used car 12 000 4 000 $16 000/$12 000 = 1.333
Buy new test equipment
have the necessary technical skills and would 10 000 2 000 $12 000/$10 000 = 1.200
Buy new notebook computer 3 000 500 $3 500/$3 000 = 1.167
welcome the opportunity to earn some pocket
Buy office building 40 000 5 000 $45 000/$40 000 = 1.125
money. To get up and running quickly, you
With $50 000 to invest, you should invest in all projects except the office building. This strategy will
would have to invest in a computer system, an
require $37 500 and is expected to result in a total NPV of $13 500. The $12 500 that you have left over
can be held in the business until an appropriate use for the money is identified, or it can be distributed
advertising campaign, three vehicles and tools.
to the shareholder (you).
You would also want to have enough cash to
keep the business going until it began to gen-
deCIsION-maKING erate positive
eX ampLe Decision-making example We emphasise the role
10.2 cash flows. All of this would require about $100 000, which is about all that you think you
can borrow on your credit cards, against your car, and from friends and family.
ranking investment alternatives
situation
You are of the financial manager as a decision maker. To that
now working on the financial forecasts for the business. You plan to charge $45 for house
calls lasting upapply
to only
30 tominutes and $25 for each additional 30 minutes. Since you expect that the typical
end, nearly every chapter includes decision-making
The profitability index concept does not a
company’s investments in projects. It can also apply to
house call will require 60 minutes, you expect it to result in revenue of $70. You also estimate that
your personal investments. For example, suppose that
monthly $50 000fixed operating
to invest it costs (FC) which include an advertising contract with a local radio station and
examples. These examples, which emphasise the
you have just inherited and want
in ways that create as much value as possible. After
a small
researching investment salaryyoufor
alternatives, you,
have identi-will total $3000. Unit VC, including the technicians’ pay, petrol and so forth, will
total
fied five investments that $20 for the
you believe typical
will have positive house call. Monthly depreciation and amortisation charges (D&A) will be $1000.
NPVs. You estimate that the NPVs and PIs for these
investments are as Finally, decision-making process rather than computation,
follows. you expect that after 6 months the business will average 120 house calls per month. Given this
information, what do you expect the monthly EBIT PIto be in 6 months?
Project
But a new car for your business
Investment
$20 000
NPV
$10 000
provide students with experience in financial decision
1.500
approach
Buy an apartment near campus 50 000 22 500 1.450
Start a small moving business 25 000 10 000
making.
1.400
Since EBIT = Revenue - VC - FC - D&A (see, for example, figure 10.5), you can forecast
Invest in your roommate’s internet business 15 000 5 000 1.333 Each decision-making example outlines a
the expected
monthly EBIT in 6 months by using this equation and the values for Revenue, VC, FC and D&A that you
Buy a collection of old comic books 5 000 1 000 1.200
expect in 6 months.
Which investment(s) should you choose? scenario and asks the student to make a decision
decision
solution
You should invest in the apartment. If you begin the selection process by choosing the new car because
The calculation is as follows:
it has the largest PI and then work your way down the list until you reach a total investment of $50 000,
based on the information presented.
you will see that you can invest in the car, the moving business and the comic books. These three
investments have a total NPV of $21 000. However, the investment in the duplex apartment alone has an
NPV of $22 500. Investing in the duplex apartment Revenue
will create more total value. $70 per house call × 120 calls $8400
This problem illustrates why the procedure for using PI to choose projects has four steps. Without the
- VC
fourth step, which tells us to repeat the third step $20 per
beginning with the second project, house
the third projectcall × 120 calls 2400
and so on, we would not have identified the apartment as the best alternative.
- FC 3000
- D&A 1000
Chapter 10 Evaluating project economics and capital rationing 361
EBIT $2000
c10EvaluatingProjectEconomicsAndCapitalRationing 361 13 January 2016 6:27 PM
Chapter 10 Evaluating project economics and capital rationing 345
that normal fluctuations in operating profits will lead to financial distress. Managers are also con-
SuMMaRY of lEaRning objECTiVES cerned with the impact of financial leverage on their reported profit, especially on a per-share
c10EvaluatingProjectEconomicsAndCapitalRationing 345 14 impact
basis. Finally, the December 2015 6:19
of capital PM decisions on who controls the company also affects
structure
14.1 Describe the two Modigliani and Miller propositions, the key assumptions underlying them,
capital structure decisions.
and their relevance to capital structure decisions.
M&M Proposition 1 states that the value of a company is unaffected by its capital structure if
the following three conditions hold: (1) there is no tax, (2) there are no information or trans-
action costs and (3) capital structure decisions do not affect the real investment policies of the KEY TERMS
company. This proposition tells us the three reasons that capital structure choices affect company
asset substitution problem the incentive that shareholders in a financially leveraged company have to
value.
substitute more risky assets for less risky assets
M&M Proposition 2 states that the expected return on a company’s equity increases with the
business risk the risk in the cash flows to shareholders that is associated with uncertainty due to the
amount of debt in its capital structure. This proposition also shows that the expected return on
characteristics of the business itself
equity can be separated into two parts — a part that reflects the risk of the underlying assets of the
company value or enterprise value the total value of the company’s assets; it equals the value of the
company and a part that reflects the risk associated with the financial leverage used by the com-
equity financing plus the value of the debt financing used by the company
pany. This proposition helps managers understand the implications of financial leverage for the
direct insolvency costs out-of-pocket costs that a company incurs when it gets into financial
cost of the equity they use to finance the company’s investments.
distress
14.2 Discuss the benefits and costs of using debt financing.
financial restructuring a combination of financial transactions that changes the capital structure of the
Using debt financing provides several benefits. A major benefit is the deductibility of interest pay- company without affecting its real assets
ments. Since interest payments are tax deductible and dividend payments are not, distributing cash financial risk the risk in the cash flows to shareholders that is due to the way in which the company
to security holders through interest payments can increase the value of a company. Debt is also has financed its activities
less expensive to issue than equity. Finally, debt can benefit shareholders in certain situations by indirect insolvency costs costs associated with changes in the behaviour of people who deal with a
providing managers with incentives to maximise the cash flows produced by the company and by company when the company gets into financial distress
reducing their ability to invest in negative NPV projects. insolvency costs or costs of financial distress costs associated with financial difficulties a company
The costs of debt include insolvency and agency costs. Insolvency costs arise because financial might experience because it uses debt financing
leverage increases the probability that a company will get into financial distress. Direct insolvency optimal capital structure the capital structure that minimises the cost of financing a company’s
costs are the out-of-pocket costs that a company incurs when it gets into financial distress, while activities
indirect insolvency costs are associated with actions the people who deal with the company take pecking order theory the theory that in financing projects, managers first use retained earnings, which
to protect their own interests when the company is in financial distress. Agency costs are costs they view as the least expensive form of capital, then debt, and finally externally raised equity, which
associated with actions taken by managers and shareholders who are acting in their own interests they view as the most expensive
rather than in the best interests of the company. When a company uses financial leverage, man- real investment policy the policy relating to the criteria the company uses in deciding which real
agers have incentives to take actions that benefit themselves at the expense of shareholders, and assets (projects) to invest in
shareholders have incentives to take actions that benefit themselves at the expense of lenders. trade-off theory the theory that managers trade off the benefits against the costs of using debt to
To the extent that these actions reduce the value of lenders’ claims, the expected losses will be identify the optimal capital structure for a company
reflected in the interest rates that lenders require. underinvestment problem the incentive that shareholders in a financially leveraged company have to
14.3 Describe the trade-off and pecking order theories of capital structure choice, and explain turn down positive NPV projects when the company is in financial distress
what the empirical evidence tells us about these theories.
The trade-off theory says that managers balance, or trade off, the benefits of debt against the
costs of debt when choosing a company’s capital structure in an effort to maximise the value
of the company. The pecking order theory says that managers raise capital as they need it in SuMMaRY of KEY EquaTionS
the least expensive way available, starting with internally generated funds, then moving to debt,
then to the sale of equity. In contrast to the trade-off theory, the pecking order theory does not Equation Description Formula
imply that managers have a particular target capital structure. There is empirical evidence that 14.1 Value of the company as the sum of the debt and VCompany = Vassets = VDebt + VEquity
supports both theories, suggesting that each helps explain the capital structure choices made by equity values
managers.
14.2 formula for weighted average cost of capital (WaCC) WaCC = xDebtkDebt + xoskos
14.4 Discuss some of the practical considerations that managers are concerned with when they for a company with only ordinary shares and no tax
choose a company’s capital structure.
Practical considerations that concern managers when they choose a company’s capital structure 14.3 Cost of ordinary shares in terms of the required return  VDebt 
kos = k assets +  (k − kDebt )
include the impact of the capital structure on financial flexibility, risk, profit and the control of the
on assets and the required return on debt  Vos  assets
company. Financial flexibility involves having the necessary financial resources to take advantage
14.4 Value of the tax savings of debt (upper bound) VTax-savings debt = D × t
of unforeseen opportunities and to overcome unforeseen problems. Risk refers to the possibility
498 part 4 Working capital management and financing decisions Chapter 14 Capital structure policy 499
Summary of learning objectives, key terms and key equations At the end of the chapter,
you will find a summary of the key chapter content related to each of the learning objectives
listed at the beginning of the chapter, a list of key terms introduced in the chapter, as well as a
list of the key equations in the chapter.
xvii HOW TO USE THIS RESOURCE

SUMMARy OF KEy EQUATIONS
Equation Description Formula
12.1 Operating cycle Operating cycle = DSO + DSI
12.2 Cash conversion cycle Cash conversion cycle = DSO + DSI – DPO
12.3 Cash conversion cycle Cash conversion cycle = Operating cycle – DPO
12.4 Effective annual rate (EAR)  Discount 

365/ days credit
EAR =  1 + -1
 Discounted price 
12.5 Economic order quantity (EOQ) 2 × Reorder costs × Sales per period
EOQ =
Carrying costs
SELF-STUDy PROBLEMS Self-study problems Five problems similar

12.1 You are provided the following working capital information for Blue Ridge Ltd:
Account Beginning balance Ending balance
to the in-text demonstration problems follow
Inventory
Accounts receivable
$ 2 600
$ 3 222
$2 890
$2 800 the summary and provide additional examples
Accounts payable $ 2 500 $2 670
Net sales
Cost of sales
$24 589
$19 630
with step-by-step solutions to help students
If all sales are made on credit, what are the company’s operating and cash conversion cycles? further develop their problem-solving and
12.2 Merrifield Cosmetics calculates that its operating cycle for last year was 76 days. The company
had $230 000 in its accounts receivable account and sales of $1.92 million. Approximately how
many days does it take from the time raw materials are received at Merrifield Cosmetics until the
computational skills.
finished products they are used to produce are sold?
12.3 Below is a partial ageing of accounts receivable for Bitar Roofing Services. Fill in the rest of
the information and determine its days’ sales outstanding. How does it compare to the industry
average of 40 days?
Age of account (days) Value of account % of total account
0–10 $ 211 000
11–30 120 360
31–45 103 220
46–60 72 800
Over 60 23 740
Total $ 531 120
12.4 Rockhampton Ltd is looking to borrow $250 000 from its bank at an APR of 8.5 per cent. The
bank requires its customers to maintain a 10 per cent compensating balance. What is the effective
interest rate on this bank loan?
CRITICAL THINKING QUESTIONS

12.1 What factors must a financial manager consider when making decisions about accounts receivable?
12.2 List some of the working capital management characteristics you would expect to see in a
computer manufacturing company following just-in-time inventory practices.
Chapter 12 Working capital management 435
c12WorkingCapitalManagement 435 15 December 2015 7:20 PM
6.5 Highland Corporation Pty Ltd, an Australian company, has a 5-year bond whose yield to maturity
is 6.5 per cent. The bond has no coupon payments. The bond has a face value of $1000. What is
the price of this zero coupon bond?
Critical thinking questions At least CRITICAL THINKING qUESTIONS

6.1 You believe that you can make abnormally profitable trades by observing that the CFO of a
ten qualitative questions, called critical certain company always wears his green suit on days that the company is about to release positive
information about itself. Describe which form of market efficiency is consistent with your belief.
thinking questions, require students to 6.2 Describe the informational differences that separate the three forms of market efficiency.
6.3 What economic conditions would prompt investors to take advantage of a bond’s convertibility
think through their understanding of key feature?

6.4 Define yield to maturity. Why is it important?
concepts and apply those concepts to a 6.5 Define interest rate risk. How can CFOs manage this risk?
6.6 Explain why bond prices and interest rates are negatively related. What is the role of the coupon
rate and term to maturity in this relationship?
problem. 6.7 If rates are expected to increase, should investors look to long-term bonds or short-term
securities? Explain.
6.8 Explain what you would assume the yield curve would look like during economic expansion and why.
6.9 An investor holds a 10-year bond paying a coupon of 9 per cent. The yield to maturity of the
bond is 7.8 per cent. Would you expect the investor to be holding a par-value, premium or
discount bond? What if the yield to maturity were 10.2 per cent? Explain.
6.10 a Investor A holds a 10-year bond, while investor B holds an 8-year bond. If the interest rate
increases by 1 per cent, which investor will have the higher interest rate risk? Explain.
b Investor A holds a 10-year bond paying 8 per cent a year, while investor B also has a 10-year bond
that pays a 6 per cent coupon. Which investor will have the higher interest rate risk? Explain.
Questions and problems The questions qUESTIONS AND PROBLEMS

and problems, numbering 30 to 40 per
 BASIC |   MODER ATE |    CHALLENGING
 Basic
chapter, are primarily quantitative and 6.1 Bond price: AR Australasia Ltd is issuing a 10-year bond with a coupon rate of 8.89 per cent.
The interest rate for similar bonds is currently 5.97 per cent. Assuming annual payments and a
face value of $1000, what is the present value of the bond?
are classified as Basic, Moderate or 6.2 Bond price: Alex Simmonds just received a gift from her grandfather. She plans to invest in a
5-year bond issued by Nucorp Pty Ltd that pays annual coupons of 4.81 per cent. If the current
Challenging. market rate is 9.11 per cent, what is the maximum amount Alex should be willing to pay for this
bond? Assume it has a face value of $1000.
6.3 Bond price: Choice Pty Ltd has issued a 3-year bond with a face value of $1000 that pays a
coupon of 4.90 per cent. Coupon payments are made semiannually. Given the market rate of
interest of 4.70 per cent, what is the market value of the bond?
6.4 Bond price: National Australia Bank Ltd has 7-year bonds outstanding that pay a 11.03 per cent
coupon rate. Investors buying the bond today can expect to earn a yield to maturity of 6.72 per cent.
What is the current value of these bonds? Assume annual coupon payments and a face value of $1000.
6.5 Bond price: You are interested in investing in a 5-year bond with a face value of $1000 that pays
a 6.33 per cent coupon with interest to be received semiannually. Your required rate of return is
9.69 per cent. What is the most you would be willing to pay for this bond?
6.6 Zero coupon bonds: Chelsea Carter is interested in buying a 5-year zero coupon bond whose
face value is $1000. She understands that the market interest rate for similar investments is
7.96 per cent. Assume annual coupon payments. What is the current price of this bond?
Chapter 6 Bond valuation and the structure of interest rates 217
c06BondValuationAndTheStructureOfInterestRates 217 27 November 2015 7:19 AM
HOW TO USE THIS RESOURCE xviii

SELECTED ABBREVIATIONS
AND NOTATION
β= beta (a measure of systematic risk)
∆= change (e.g. DP = change in price level, DS = change in sales level)
ρ= correlation
σ2 (σ) = variance (standard deviation)
x= fractional weight of investment or component of capital
Add WC = addition to working capital
APR = annual percentage rate
ARR = accounting rate of return
C= coupon payment (bond)
Cap Exp = capital expenditures
CF = cash flow
CF Opns = cash flow from operations
CIP = call interest premium
CO = crossover level of unit sales
COS = cost of sales
CV = coefficient of variation
D= dividend (stock)
D&A = depreciation and amortisation
DOL = degree of operating leverage
DPO = days’ payables outstanding
DRP = default risk premium
DSI = days’ sales in inventory
DSO = days’ sales outstanding
E(•) = expected value (E(R) = expected return, etc.)
EAC = equivalent annual cost
EAR = EAY = effective annual rate (yield)
EBIT = earnings before interest and tax
EBITDA = earnings before interest, tax, depreciation and amortisation
EBT = earnings before tax
EFN = external funding needed
EOQ = economic order quantity
EROA = EBIT return on assets
F= face value (bond)
FC = fixed costs
FCF = free cash flows
FCFE = free cash flow to equity
FCFC = free cash flow from the company
FV = future value
FVAn = future value of an annuity
FXR = foreign exchange or currency risk premium
g= growth rate
i= nominal rate of interest
IGR = internal growth rate
IRR = internal rate of return
k= cost of capital (debt or equity)
m= number of payments per year
MAT = maturity adjustment to cost of a loan
MRP = marketability risk premium
MV = market value
n= number of periods
NCF = net cash flow
NCFOA = net cash flow from operating activities
NOPAT = net operating profits after tax
NPV = net present value
NWC = net working capital
OC = operating cycle
Op Ex = cash operating expenses
p= probability
P= price (P0 = price at time zero, etc.)
P/E ratio = price/earnings ratio
PB = payback period
PI = profitability index
PR = prime rate
PV = present value
PV annuity factor = present value of annuity factor
PVAn = present value of an annuity
r= real rate of interest
R= return (Rrf = risk free, Ri, RPortfolio, etc.)
ROA = return on assets
ROE = return on equity
SGR = sustainable growth rate
t= tax rate
TV = terminal value
V= value (e.g. VFirm = VAssets = VDebt + VEquity)
VC = variable costs
WACC = weighted average cost of capital
xx SELECTED ABBREVIATIONS AND NOTATION

PART 1
Introduction
1 The financial manager and the company 2
2 The financial environment and the level of interest rates 28

CHAPTER 1
The financial manager

and the company
LEA RN IN G OBJE CTIVE S
After studying this chapter, you should be able to:

1.1 identify the key financial decisions facing the financial manager of any company
1.2 identify the basic forms of business organisation used in Australia, and review their respective
strengths and weaknesses
1.3 describe the typical organisation of the financial function in a large company
1.4 explain why maximising the current value of the company’s shares is the appropriate goal for
management
1.5 discuss how agency conflicts affect the goal of maximising shareholder value
1.6 explain why ethics is an appropriate topic in the study of corporate finance.
Financial managers are continually faced with making decisions to maximise the current value of the
company’s shares. Geoff Babidge, CEO of the a2 Milk Company, is targeting developed markets rather
than the fast-growing Asian markets. This may appear to be odd considering many consumers are
reducing their intake of dairy. However, the a2 milk is not like other dairy products.
The a2 Milk Company produces dairy products from cows’ milk that contain only the A2 betacasein,
whereas most milk contains both A1 and A2 betacaseins. Studies have shown that A2-only milk digests
differently and is therefore a real solution for millions of people who have trouble digesting dairy
products. Mr Babidge said that competitors cannot easily mimic its process as it is secured by a series
of patents and trademarks. It is this unique feature of their products that differentiate a2 Milk Co. from
competitors.
The science behind a2 was identified in New Zealand but its success has been largely due to the
Australian market. Its fresh milk and infant formula sell at a premium even though Coles and Woolworths
sell home-brand milk for $1 per litre. The New Zealand company expanded into the Australian market
in 2007 and now supplies 9 per cent of the Australian fresh milk grocery channel by value. Mr Babidge
said he will fund moving into the United Kingdom and the United States from the solid base he’s built
in Australia. a2 plan on investing US$20 million in the US over the next three years.
Even though the company is listed in New Zealand, its stock began trading on the Australian Securities
Exchange on 31 March 2015 to boost the liquidity of a2 shares and broaden the potential investor and
capital base in case equity issues are required during this growth phase. The company is currently
investing heavily in starting up its business in the UK and US, and expanding its infant formula sales
in China, leaving little profit. In addition, a2 is considering launching cheese and ice-cream products
in Australia. Its priority, at this time, is growing the business. In 2013–14 a2 Milk reported revenue of
NZ$110.6 million ($108 million) and aims to more than double revenue to NZ$230 million by 2015–16.
Company managements use many of the concepts covered in this and later chapters to create the most
possible value. Managers create value by investing only in projects whose benefits exceed their costs, by
managing the assets of the company as efficiently as possible, and by financing the company with the
CHAPTER 1 The financial manager and the company 3

least expensive combination of debt and equity. This chapter introduces you to the key financial aspects
of these activities and the remainder of this text fills in many of the details.1
Chapter preview
This text provides an introduction to corporate finance. In it we focus on the responsibilities of the finan-
cial manager, who oversees the accounting and treasury functions and sets the overall financial strategy
for the company. We pay special attention to the financial manager’s role as a decision maker. To that
end, we emphasise the mastery of fundamental finance concepts and the use of a set of financial tools,
which will result in sound financial decisions that create value for shareholders. These financial concepts
and tools apply not only to business organisations but also to other organisations, such as government
entities, not-for-profit organisations and sometimes even your own personal finances.
We open this chapter by discussing the three major types of decisions that a financial manager makes:
capital budgeting decisions, financing decisions and working capital management decisions. We then
describe common forms of business organisation. After next discussing the major responsibilities of the
financial manager, we explain why maximising the price of the company’s shares is an appropriate goal
for a financial manager. We go on to describe the conflicts of interest that can arise between shareholders
and managers and the mechanisms that help align the interests of these two groups. Finally, we discuss
the importance of ethical conduct in business.
1.1 The role of the financial manager

LEARNING OBJECTIVE 1.1 Identify the key financial decisions facing the financial manager of any company.
The financial manager is responsible for making decisions that are in the best interests of the business’s
owners, whether it is a start-up business with a single owner or a billion-dollar company owned by thou-
sands of shareholders. The decisions made by the financial manager or owner should be one and the
same. In most situations this means that the financial manager should make decisions that maximise the
value of the owners’ shares. This helps maximise the owners’ wealth. Our underlying assumption in this
text is that most people who invest in businesses do so because they want to increase their wealth. In the
following discussion, we describe the responsibilities of the financial manager in a new business in order
to illustrate the types of decisions that such a manager makes.
Stakeholders
Before we discuss the new business, you may want to look at figure 1.1, which shows the cash flows
between a company and its owners (in a company, the shareholders) and various stakeholders. A
stakeholder is someone other than an owner who has a claim on the cash flows of the company: man-
agers, who want to be paid salaries and performance bonuses; creditors, who want to be paid interest
and principal; employees, who want to be paid wages; suppliers, who want to be paid for goods or ser-
vices; and the government, which wants the company to pay tax. Stakeholders may have interests that
differ from those of the owners. When this is the case, they may exert pressure on management to make
decisions that benefit them. We will return to these types of conflict of interest later in the text. For now,
though, we are primarily concerned with the overall flow of cash between the company and its share-
holders and stakeholders.
It’s all about cash flows

To produce its goods or services, a new company needs to acquire a variety of assets. Most will be long-
term assets or productive assets. Productive assets can be tangible assets, such as equipment, machinery
or a manufacturing facility, or intangible assets, such as patents, trademarks, technical expertise or other
types of intellectual capital. Regardless of the type of asset, the company tries to select assets that will
4 PART 1 Introduction
generate the greatest profits. The decision-making process through which the company purchases long-
term productive assets is called capital budgeting, and it is one of the most important decision processes
in a company.
Stakeholders and
The company shareholders
A Company’s
Managers
Cash flows are generated management Cash paid as
and other
by productive assets invests in assets wages and salaries
employees
through the sale of Current assets
goods and services. • Cash
• Inventory Cash paid to
Suppliers
• Accounts suppliers
receivable
Productive assets Cash paid

Government
• Plant as tax
• Equipment
• Buildings
• Technology Cash paid as
Creditors
• Patents interest and principal
B Shareholders
Residual cash flow
Cash flow reinvested Dividends paid to

in business shareholders
FIGURE 1.1 Cash flows between the company and its stakeholders and owners
A. Making business decisions is all about cash flows, because only cash can be used to pay bills
and buy new assets. Cash initially flows into the company as a result of the sale of goods or
services. The company uses these cash inflows in a number of ways: to invest in assets, to
pay wages and salaries, to buy supplies, to pay taxes and to repay creditors.
B. Any cash that is left over (residual cash flows) can be reinvested in the business or paid as
dividends to shareholders.
Once the company has selected its productive assets, it must raise money to pay for them. Financing
decisions are concerned with the ways in which companies obtain and manage long-term financing to
acquire and support their productive assets. There are two basic sources of funds: debt and equity. Every
company has some equity because equity represents ownership in the company. It consists of capital
contributions by the owners plus earnings that have been reinvested in the company. In addition, most
companies borrow from a bank or issue some type of long-term debt to finance productive assets.
After the productive assets have been purchased and the business is operating, the company will try to
produce products at the lowest possible cost while maintaining quality. This means buying raw materials
at the lowest possible cost, holding production and labour costs down, keeping management and admin-
istrative costs to a minimum, and seeing that shipping and delivery costs are competitive. In addition,
the company must manage its day-to-day finances so that it will have sufficient cash on hand to pay
salaries, purchase supplies, maintain inventories, pay tax and cover the myriad other expenses necessary
to run a business. The management of current assets (such as money owed by customers who purchase
on credit), inventory, and current liabilities (such as money owed to suppliers), is called working capital
management.2

A company generates cash flows by selling the goods and services it produces. A company is suc-
cessful when these cash inflows exceed the cash outflows needed to pay operating expenses, creditors
and tax. After meeting these obligations, the company can pay the remaining cash, called residual cash
flows, to the owners as a cash dividend or it can reinvest the cash in the business. The reinvestment of
residual cash flows back into the business to buy more productive assets is a very important concept. If
these funds are invested wisely, they provide the foundation for the company to grow and provide larger
residual cash flows in the future for the owners. The reinvestment of cash flows (earnings) is the most
fundamental way that businesses grow in size. Figure 1.1 illustrates how the revenue generated by pro-
ductive assets ultimately becomes residual cash flow.
A company is unprofitable when it fails to generate sufficient cash inflows to pay operating expenses,
creditors and tax. Companies that are unprofitable over time will be forced into insolvency by their
creditors if the owners do not shut them down first. In insolvency, the company will be reorganised
or the company’s assets will be liquidated, whichever is more valuable. If the company is liquidated,
creditors are paid in a priority order according to the structure of the company’s financial contracts and
prevailing insolvency law. If anything is left after all creditor and tax claims have been satisfied, which
usually does not happen, the remaining cash, or residual value, is distributed to the owners.
KEY POINT
Cash flows matter most to investors

Cash is what investors ultimately care about when making an investment. The value of any asset —
shares, bonds or a business — is determined by the future cash flows it will generate. To understand
this concept, just consider how much you would pay for an asset from which you could never expect
to obtain any cash flows. Buying such an asset would be like giving your money away. It would have a
value of exactly zero. Conversely, as the expected cash flows from an investment increase, you would
be willing to pay more and more for it.
Three fundamental decisions in financial management

Based on our discussion so far, we can see that financial managers are concerned with three fundamental
decisions when running a business:
1. capital budgeting decisions: identifying the productive assets the company should buy
2. financing decisions: determining how the company should finance or pay for assets
3. working capital management decisions: determining how day-to-day financial matters should be man-
aged so that the company can pay its bills, and how surplus cash should be invested.
Figure 1.2 shows the impact of each decision on the company’s balance sheet. (Note that the bal-
ance sheet can also be called the statement of financial position but the term balance sheet will be used
throughout this text.) We briefly introduce each decision here and discuss them in greater detail in later
chapters.
Capital budgeting decisions
A company’s capital budget is simply a list of the productive (capital) assets management wants to
purchase over a budget cycle; typically 1 year. The capital budgeting decision process addresses which
productive assets the company should purchase and how much money the company can afford to spend.
As shown in figure 1.2, capital budgeting decisions affect the asset side of the balance sheet and are con-
cerned with a company’s long-term investments. Capital budgeting decisions, as we mentioned earlier,
are among management’s most important decisions. Over the long run, they have a large impact on the
company’s success or failure. The reason is twofold. First, capital assets generate most of the cash flows
for the company. Second, capital assets are long term in nature. Once they are purchased, the company
owns them for a long time, and they may be hard to sell without taking a financial loss.
Balance sheet
Assets Liabilities and equity
Working capital
management decisions Current liabilities
deal with day-to-day financial (including
Current assets matters and affect current short-term debt and
(including cash, assets, current liabilities and accounts payable)
inventory and net working capital.
accounts receivable)
Net working capital — the
difference between current
assets and current liabilities
Long-term debt
Capital budgeting (debt with a
decisions maturity of over
determine what long-term 1 year)
productive assets the
Long-term company will purchase.
assets (including Financing decisions
productive assets; determine the company’s
may be tangible capital structure — the
or intangible) combination of long-term
debt and equity that will Shareholders’
be used to finance the equity
company’s long-term
productive assets.
FIGURE 1.2 How the financial manager’s decisions affect the balance sheet
Financial managers are concerned with three fundamental types of decisions: capital budgeting
decisions, financing decisions and working capital management decisions. Each type of decision
has a direct and important effect on the company’s balance sheet — in other words, on the
company’s profitability.
The fundamental question in capital budgeting is this: which productive assets should the company
purchase? A capital budgeting decision may be as simple as a movie theatre’s decision to buy a popcorn
machine or as complicated as Airbus’ decision to invest more than $10 billion to design and build the
Airbus A380 passenger jet. Capital investments may also involve the purchase of an entire business, such
as Woolworths Limited’s acquisition of hardware distributor Danks to compete with home-improvement
giant Bunnings.
Regardless of the project, a good capital budgeting decision is one in which the benefits are worth
more to the company than the cost of the asset. For example, in 2015 Stockland purchased a 143 hec-
tare development site in the Redcliffe Peninsula for $67 million. It plans to build 1500 new homes and
a village centre with work due to commence in 2016. Stockland expects that the project will produce
a stream of cash flows worth $590 million. Is the acquisition a good deal for Stockland? The answer is
yes if the value of the cash flow benefits from the project exceeds the cost. If the project works out as
planned, the value of Stockland will be increased by the amount recouped above the total cost of the
project.3
Not all investment decisions are successful. Just open the business section of any newspaper on any
day, and you will find stories of bad decisions. For example, Disney’s movie Mars Needs Moms turned
out to be a flop. The film cost US$150 million to make but grossed only US$39 million worldwide. After
flopping at the box office, it is unlikely that the movie’s overall cash flow (from box office takings, DVD

sales, merchandise and so on) will be worth more than its $150 million cost. When, as in this case, the
cost exceeds the value of the future cash flows, the project will decrease the value of the company by
that amount.
KEY POINT
Sound investments are those where the value of the benefits exceeds
their costs
Financial managers should invest in a capital project only if the value of its future cash flows exceeds
the cost of the project (benefits > cost). Such investments increase the value of the company and thus
increase shareholders’ (owners’) wealth. This rule holds whether you are making the decision to pur-
chase new machinery, build a new plant or buy an entire business.
Financing decisions
Financing decisions concern how companies raise cash to pay for their investments, as shown in
figure 1.2. Productive assets, which are long term in nature, are financed by long-term borrowing, equity
investment or both. Financing decisions involve trade-offs between advantages and disadvantages to the
company.
A major advantage of debt financing is that debt payments are tax deductible for many companies.
However, debt financing increases a company’s risk because it creates a contractual obligation to make
periodic interest payments and, at maturity, to repay the amount that is borrowed. Contractual obli-
gations must be paid regardless of the company’s operating cash flow, even if the company suffers a
financial loss. If the company fails to make payments as promised, it defaults on its debt obligation and
could be forced into insolvency.
In contrast, equity has no maturity, and there are no guaranteed payments to equity investors. In a
company, the board of directors has the right to decide whether dividends should be paid to shareholders.
This means that if the board decides to omit or reduce a dividend payment, the company will not be in
default. Unlike interest payments, however, dividend payments to shareholders are not tax deductible.
The mix of debt and equity on the balance sheet is known as a company’s capital structure. The
term capital structure is used because long-term funds are considered capital, and these funds are raised
in capital markets — financial markets where equity and debt instruments with maturities greater than
1 year are traded.
KEY POINT
Financing decisions affect the value of the company

How a company is financed with debt and equity affects the value of the company. The reason is that
the mix between debt and equity affects the tax the company pays and the probability that the company
will become insolvent. The financial manager’s goal is to determine the combination of debt and equity
that minimises the cost of financing the company.
Working capital management decisions

Management must also decide how to manage the company’s current assets, such as cash, inventory
and accounts receivable, and its current liabilities, such as trade credit and accounts payable. The dollar
difference between current assets and current liabilities is called net working capital, as shown in
figure 1.2. As mentioned earlier, working capital management is the day-to-day management of the
company’s short-term assets and liabilities. The goals of managing working capital are to ensure that
the company has enough money to pay its bills and to profitably invest any spare cash to earn interest.
The mismanagement of working capital can cause a company to default on its debt and become
insolvent even though, over the long term, the company may be profitable. For example, a company
that makes sales to customers on credit but is not diligent about collecting the accounts receivable can
quickly find itself without enough cash to pay its bills. If this condition becomes chronic, trade creditors
can force the company into insolvency if the company cannot obtain alternative financing.
A company’s profitability can also be affected by its inventory level. If the company has more inven-
tory than it needs to meet customer demands, it has too much money tied up in non-earning assets.
Conversely, if the company holds too little inventory, it can lose sales because it does not have products
to sell when customers want them. The company must therefore determine the optimal inventory level.
BEFORE YOU GO ON
1. What are the three most basic types of financial decisions managers must make?
2. Why are capital budgeting decisions among the most important decisions in the life of a company?
3. Explain why you would accept an investment project if the value of the expected cash flows exceeds the
cost of the project.
1.2 Forms of business organisation

LEARNING OBJECTIVE 1.2 Identify the basic forms of business organisation used in Australia, and
review their respective strengths and weaknesses.
In this section we look at the way companies organise to conduct their business activities. The owners
of a business usually choose the organisational form that will help management to maximise the value
of the company. Important considerations are the size of the business, the manner in which income
from the business is taxed, the legal liability of the owners, and the ability to raise cash to finance the
business.
Most start-ups and small businesses operate as either sole traders or partnerships because of their
small operating scale and capital requirements. Large businesses in Australia, such as Woolworths Lim-
ited, are most often organised as companies. As a business grows larger, the benefits to organising as a
company become greater and are more likely to outweigh any disadvantages.
Sole traders
A sole trader is a business owned by one person, typically consisting of the trader and a handful of
employees. Becoming a sole trader offers several advantages. It is the simplest type of business to start,
and it is the least regulated. In addition, sole traders keep all the profits from the business and do not
have to share decision-making authority. From the taxation point of view, business losses can be written
off against the sole trader’s tax from other employment under certain circumstances.
On the downside, a sole trader has unlimited liability for all the business’s debts and other obligations.
This means that creditors can look beyond the assets of the business to the trader’s personal wealth for
payment. Another disadvantage is that the amount of equity capital that can be invested in the business
is limited to the owner’s personal wealth, which may restrict the possibilities for growth. Finally, it is
difficult to transfer ownership of a sole trader because there are no shares or other such interest to sell.
Partnerships
A partnership consists of two or more owners who have joined together legally to manage a business.
Partnerships are typically larger than sole trader businesses. In forming a partnership, it is recommended
that a formal partnership agreement is drawn up on the roles and authority of each partner, how much
capital each partner will contribute to the partnership, how key management decisions will be made, how

the profits will be divided, who has limited liability, how the partnership will be closed down and assets
distributed, and how disputes will be dealt with.
The key advantages of partnerships are similar to those of sole traders. In addition, partnerships have
access to more capital, and the pooling of knowledge, experience and skills. The key drawbacks of
partnership are possible disputes among the partners over profit sharing, administration and business
development. Also, each partner is personally responsible for business debts and liabilities incurred by
the other partners. The problem of unlimited liability can be avoided in a limited partnership, which
consists of general and limited partners. Here, one or more general partners have unlimited liability and
actively manage the business, while each limited partner is liable for business obligations only up to
the amount of capital he or she contributed to the partnership. In other words, the limited partners have
limited liability. To qualify for limited partner status, a partner cannot be actively engaged in managing
the business.
Companies
Most large businesses are companies. A company is an independent legal entity able to do business in its
own right. In a legal sense, it is a ‘person’ distinct from its owners. Companies can sue and be sued, enter
into contracts, issue debt, borrow money and own assets. The owners of a company are its shareholders.
Starting a company is more costly than starting a business as a sole trader or partnership. Those
starting the company, for example, must set out a ‘memorandum’ that details its powers, and the ‘articles
of association’ to describe who can use these powers. All companies are registered with and regulated by
the Australian Securities and Investments Commission (ASIC).
A major advantage of the company form of business structure is that shareholders have limited lia-
bility for debts and other obligations of the company. However, directors and employees are personally
liable under the Corporations Act 2001 if found to be committing fraudulent, negligent or reckless acts.
The major disadvantages of the company form are the cost to establish and register, and the higher com-
pliance costs and stricter record-keeping requirements as compared to other forms of business structure.
A company can also list on a stock exchange, such as the Australian Securities Exchange (ASX), as
a public company to attract investors. In contrast, private companies are typically owned by a small
number of key managers and shareholders. Over time, as the company grows in size and needs larger
amounts of capital, management may decide that the company should ‘go public’ in order to gain access
to the public markets.
BEFORE YOU GO ON
1. Why are many businesses operated as sole traders?

2. What are some advantages and disadvantages of operating as a partnership?
3. What are some advantages and disadvantages of operating as a company?
1.3 Managing the financial function

LEARNING OBJECTIVE 1.3 Describe the typical organisation of the financial function in a large company.
As we discussed earlier in the chapter, financial managers are concerned with a company’s investment,
financing and working capital management decisions. The senior financial manager holds one of the
top executive positions in the company. In a large company, the senior financial manager usually has
the rank of deputy chief executive or senior executive and goes by the title of chief financial officer, or
CFO. In smaller companies, the job tends to focus more on the accounting function, and the top finan-
cial officer may be called the controller or chief accountant. In this section we focus on the financial
function in a large company.
Organisation structure
Figure 1.3 shows a typical organisational structure for a large company, with special attention to the
financial function. As shown, the top management position in the company is the chief executive officer
(CEO), who has the final decision-making authority among all the company’s executives. The CEO’s
most important responsibilities are to set the strategic direction of the company and see that the man-
agement team executes the strategic plan. The CEO reports directly to the board of directors, which is
accountable to the company’s shareholders. The board’s responsibility is to see that the top management
makes decisions that are in the best interest of the shareholders.
The CFO reports directly to the CEO and focuses on managing all aspects of the company’s financial
side, as well as working closely with the CEO on strategic issues. A number of positions report directly
to the CFO. In addition, the CFO often interacts with people in other functional areas on a regular basis
because all senior executives are involved in financial decisions that affect the company and their areas
of responsibility.
Shareholders control Shareholders
Board controls
Board of directors Audit committee
CEO controls
Chief executive
CFO controls External auditor
officer (CEO)
Chief information officer (CIO) Chief financial officer (CFO) Chief operating officer (COO)
Treasurer Risk manager Controller Internal auditor
• Cash payments/ • Monitor company’s • Financial accounting • Audit high-risk

collections risk exposure in • Cost accounting areas
• Foreign exchange financial and • Taxes • Prepare working
• Superannuation commodities • Accounting papers for
• Derivatives hedging markets information system external auditor
• Marketable • Design strategies • Prepare financial • Internal consulting
securities portfolio for limiting risk statements for cost savings
• Manage insurance • Internal fraud
portfolio monitoring and
investigation
FIGURE 1.3 Simplified company organisation chart

The company’s top finance and accounting executive is the CFO, who reports directly to the CEO.
Positions that report directly to the CFO include the treasurer, risk manager and controller. The
internal auditor reports both to the CFO and to the audit committee of the board of directors.
Positions reporting to the CFO

Figure 1.3 also shows the positions that typically report to the CFO in a large company and the activities
managed in each area.
•• The treasurer looks after the collection and disbursement of cash, investing excess cash so that it
earns interest, raises new capital, handles foreign exchange transactions and oversees the company’s
superannuation arrangements. The treasurer also assists the CFO in handling important financial
relationships, such as those with investment bankers and credit rating agencies.

•• The risk manager monitors and manages the company’s risk exposure in financial and commodity
markets and the company’s relationships with insurance providers.
•• The controller is really the company’s chief accounting officer. The controller’s staff prepares the
financial statements, maintains the company’s financial and cost accounting systems, prepares the tax
returns, and works closely with the company’s external auditors.
•• The internal auditor is responsible for identifying and assessing major risks facing the company and
performing audits in areas where the company might incur substantial losses. The internal auditor
reports to the board of directors as well as the CFO.
External auditors
Nearly every large business entity hires a licensed public accounting firm to provide an independent
annual audit of their company’s financial statements. Through this audit the accountant comes to a con-
clusion as to whether the company’s financial statements present fairly, in all material respects, the finan-
cial position of the company and results of its activities. In other words, whether the financial numbers
are reasonably accurate, accounting principles have been consistently applied year to year and do not
significantly distort the company’s performance, and the accounting principles used conform to those
generally accepted by the accounting profession. Creditors and investors require independent audits, and
ASIC requires large private companies and all public companies to supply audited financial statements.
The audit committee

The audit committee, a powerful subcommittee of the board of directors, has the responsibility of over-
seeing the accounting function and the preparation of the company’s financial statements. In addition,
the audit committee oversees or, if necessary, conducts investigations of significant fraud, theft or mal-
feasance in the company, especially if it is suspected that senior managers in the company may be
involved.
External auditors report directly to the audit committee to help ensure their independence from man-
agement. On a day-to-day basis, however, they work closely with the CFO staff. The internal auditor
also reports to the audit committee so that the position is more independent from management, and his
or her ultimate responsibility is to the audit committee. On a day-to-day basis, however, the internal
auditor, like the external auditors, works closely with the CFO staff.
BEFORE YOU GO ON
1. What are the major responsibilities of the CFO?

2. Identify three financial officers who typically report to the CFO and describe their duties.
3. Why should the company’s accounts be audited by an external auditor?
1.4 The goal of the company

LEARNING OBJECTIVE 1.4 Explain why maximising the current value of the company’s shares is the
appropriate goal for management.
For business owners, it is important to determine the appropriate goal for financial management decisions.
Should the goal be to try to keep costs as low as possible? or to maximise sales or market share? or to
achieve steady growth and earnings? Let’s look at this fundamental question more closely.
What should management maximise?

Suppose you own and manage a pizza restaurant. Depending on your preferences and tolerance for risk,
you can set any goal for the business that you want. For example, you might have a fear of insolvency
and losing money. To avoid the risk of insolvency, you could focus on keeping your costs as low as poss-
ible, paying low wages, avoiding borrowing, advertising minimally and remaining reluctant to expand
the business. In short, you will avoid any action that increases your business’s risk. You will sleep well
at night, but you may eat poorly because of meagre profits.
Conversely, you could focus on maximising market share and becoming the largest pizza business in
town. Your strategy might include cutting prices to increase sales, borrowing heavily to open new pizza
restaurants, spending lavishly on advertising and developing menu items using exotic toppings. In the
short term, your high-risk, high-growth strategy will have you both eating poorly and sleeping poorly as
you push the business to the edge. In the long term, you will either become very rich or become insol-
vent! There must be a better operational goal than either of these extremes.
Why not maximise profits?

One goal for financial decision making that seems reasonable is profit maximisation. After all, don’t
shareholders and business owners want their companies to be profitable? Although profit maximisation
seems a logical goal for a business, it has some serious drawbacks.
One problem with profit maximisation is that it is hard to pin down what is meant by ‘profit.’ To the
average businessperson, profits are just revenues minus expenses. To an accountant, however, a decision
that increases profit under one set of accounting rules can reduce it under another. This is the origin of
the term creative accounting. A second problem is that accounting profits are not necessarily the same
as cash flows. For example, many companies recognise revenues at the time a sale is made, which is
typically before the cash payment for the sale is received. Ultimately, the owners of a business want cash
because only cash can be used to make investments or to buy goods and services.
Yet another problem with profit maximisation as a goal is that it does not distinguish between
getting a dollar today and getting a dollar some time in the future. In finance, the timing of cash
flows is extremely important. For example, the longer you go without paying your credit card bal-
ance, the more interest you must pay the bank for the use of the money. The interest accrues because
of the time value of money; the longer you have access to money, the more you have to pay for it.
The time value of money is one of the most important concepts in finance and is the focus of later
chapters.
KEY POINT
The timing of cash flows affects their value

A dollar today is worth more than a dollar in the future because if you have a dollar today, you can
invest it and earn interest. For businesses, cash flows can involve large sums of money, and receiving
money one day late can cost a great deal. For example, if a bank has $100 billion of consumer loans
outstanding and the average annual interest payment is 5 per cent, it would cost the bank $13.7 million
if every consumer decided to make an interest payment one day later.
Finally, profit maximisation ignores the uncertainty, or risk, associated with cash flows. A basic
principle of finance is that there is a trade-off between expected return and risk. When given a choice
between two investments that have the same expected returns but different risk, most people choose
the less risky one. This makes sense because most people do not like bearing risk and, as a result, must
be compensated for taking it. The profit maximisation goal ignores differences in value caused by dif-
ferences in risk. We will discuss the important topics of risk, its measurement, and the trade-off between
risk and return in coming chapters. What is important at this time is that you understand that investors do
not like risk and must be compensated for bearing it.

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DANCE ON STILTS AT THE GIRLS’ UNYAGO, NIUCHI
Newala, too, suffers from the distance of its water-supply—at least

the Newala of to-day does; there was once another Newala in a lovely
valley at the foot of the plateau. I visited it and found scarcely a trace
of houses, only a Christian cemetery, with the graves of several
missionaries and their converts, remaining as a monument of its
former glories. But the surroundings are wonderfully beautiful. A
thick grove of splendid mango-trees closes in the weather-worn
crosses and headstones; behind them, combining the useful and the
agreeable, is a whole plantation of lemon-trees covered with ripe
fruit; not the small African kind, but a much larger and also juicier
imported variety, which drops into the hands of the passing traveller,
without calling for any exertion on his part. Old Newala is now under
the jurisdiction of the native pastor, Daudi, at Chingulungulu, who,
as I am on very friendly terms with him, allows me, as a matter of
course, the use of this lemon-grove during my stay at Newala.
FEET MUTILATED BY THE RAVAGES OF THE “JIGGER”
(Sarcopsylla penetrans)
The water-supply of New Newala is in the bottom of the valley,

some 1,600 feet lower down. The way is not only long and fatiguing,
but the water, when we get it, is thoroughly bad. We are suffering not
only from this, but from the fact that the arrangements at Newala are
nothing short of luxurious. We have a separate kitchen—a hut built
against the boma palisade on the right of the baraza, the interior of
which is not visible from our usual position. Our two cooks were not
long in finding this out, and they consequently do—or rather neglect
to do—what they please. In any case they do not seem to be very
particular about the boiling of our drinking-water—at least I can
attribute to no other cause certain attacks of a dysenteric nature,
from which both Knudsen and I have suffered for some time. If a
man like Omari has to be left unwatched for a moment, he is capable
of anything. Besides this complaint, we are inconvenienced by the
state of our nails, which have become as hard as glass, and crack on
the slightest provocation, and I have the additional infliction of
pimples all over me. As if all this were not enough, we have also, for
the last week been waging war against the jigger, who has found his
Eldorado in the hot sand of the Makonde plateau. Our men are seen
all day long—whenever their chronic colds and the dysentery likewise
raging among them permit—occupied in removing this scourge of
Africa from their feet and trying to prevent the disastrous
consequences of its presence. It is quite common to see natives of
this place with one or two toes missing; many have lost all their toes,
or even the whole front part of the foot, so that a well-formed leg
ends in a shapeless stump. These ravages are caused by the female of
Sarcopsylla penetrans, which bores its way under the skin and there
develops an egg-sac the size of a pea. In all books on the subject, it is
stated that one’s attention is called to the presence of this parasite by
an intolerable itching. This agrees very well with my experience, so
far as the softer parts of the sole, the spaces between and under the
toes, and the side of the foot are concerned, but if the creature
penetrates through the harder parts of the heel or ball of the foot, it
may escape even the most careful search till it has reached maturity.
Then there is no time to be lost, if the horrible ulceration, of which
we see cases by the dozen every day, is to be prevented. It is much
easier, by the way, to discover the insect on the white skin of a
European than on that of a native, on which the dark speck scarcely
shows. The four or five jiggers which, in spite of the fact that I
constantly wore high laced boots, chose my feet to settle in, were
taken out for me by the all-accomplished Knudsen, after which I
thought it advisable to wash out the cavities with corrosive
sublimate. The natives have a different sort of disinfectant—they fill
the hole with scraped roots. In a tiny Makua village on the slope of
the plateau south of Newala, we saw an old woman who had filled all
the spaces under her toe-nails with powdered roots by way of
prophylactic treatment. What will be the result, if any, who can say?
The rest of the many trifling ills which trouble our existence are
really more comic than serious. In the absence of anything else to
smoke, Knudsen and I at last opened a box of cigars procured from
the Indian store-keeper at Lindi, and tried them, with the most
distressing results. Whether they contain opium or some other
narcotic, neither of us can say, but after the tenth puff we were both
“off,” three-quarters stupefied and unspeakably wretched. Slowly we
recovered—and what happened next? Half-an-hour later we were
once more smoking these poisonous concoctions—so insatiable is the
craving for tobacco in the tropics.
Even my present attacks of fever scarcely deserve to be taken
seriously. I have had no less than three here at Newala, all of which
have run their course in an incredibly short time. In the early
afternoon, I am busy with my old natives, asking questions and
making notes. The strong midday coffee has stimulated my spirits to
an extraordinary degree, the brain is active and vigorous, and work
progresses rapidly, while a pleasant warmth pervades the whole
body. Suddenly this gives place to a violent chill, forcing me to put on
my overcoat, though it is only half-past three and the afternoon sun
is at its hottest. Now the brain no longer works with such acuteness
and logical precision; more especially does it fail me in trying to
establish the syntax of the difficult Makua language on which I have
ventured, as if I had not enough to do without it. Under the
circumstances it seems advisable to take my temperature, and I do
so, to save trouble, without leaving my seat, and while going on with
my work. On examination, I find it to be 101·48°. My tutors are
abruptly dismissed and my bed set up in the baraza; a few minutes
later I am in it and treating myself internally with hot water and
lemon-juice.
Three hours later, the thermometer marks nearly 104°, and I make
them carry me back into the tent, bed and all, as I am now perspiring
heavily, and exposure to the cold wind just beginning to blow might
mean a fatal chill. I lie still for a little while, and then find, to my
great relief, that the temperature is not rising, but rather falling. This
is about 7.30 p.m. At 8 p.m. I find, to my unbounded astonishment,
that it has fallen below 98·6°, and I feel perfectly well. I read for an
hour or two, and could very well enjoy a smoke, if I had the
wherewithal—Indian cigars being out of the question.
Having no medical training, I am at a loss to account for this state
of things. It is impossible that these transitory attacks of high fever
should be malarial; it seems more probable that they are due to a
kind of sunstroke. On consulting my note-book, I become more and
more inclined to think this is the case, for these attacks regularly
follow extreme fatigue and long exposure to strong sunshine. They at
least have the advantage of being only short interruptions to my
work, as on the following morning I am always quite fresh and fit.
My treasure of a cook is suffering from an enormous hydrocele which
makes it difficult for him to get up, and Moritz is obliged to keep in
the dark on account of his inflamed eyes. Knudsen’s cook, a raw boy
from somewhere in the bush, knows still less of cooking than Omari;
consequently Nils Knudsen himself has been promoted to the vacant
post. Finding that we had come to the end of our supplies, he began
by sending to Chingulungulu for the four sucking-pigs which we had
bought from Matola and temporarily left in his charge; and when
they came up, neatly packed in a large crate, he callously slaughtered
the biggest of them. The first joint we were thoughtless enough to
entrust for roasting to Knudsen’s mshenzi cook, and it was
consequently uneatable; but we made the rest of the animal into a
jelly which we ate with great relish after weeks of underfeeding,
consuming incredible helpings of it at both midday and evening
meals. The only drawback is a certain want of variety in the tinned
vegetables. Dr. Jäger, to whom the Geographical Commission
entrusted the provisioning of the expeditions—mine as well as his
own—because he had more time on his hands than the rest of us,
seems to have laid in a huge stock of Teltow turnips,[46] an article of
food which is all very well for occasional use, but which quickly palls
when set before one every day; and we seem to have no other tins
left. There is no help for it—we must put up with the turnips; but I
am certain that, once I am home again, I shall not touch them for ten
years to come.
Amid all these minor evils, which, after all, go to make up the
genuine flavour of Africa, there is at least one cheering touch:
Knudsen has, with the dexterity of a skilled mechanic, repaired my 9
× 12 cm. camera, at least so far that I can use it with a little care.
How, in the absence of finger-nails, he was able to accomplish such a
ticklish piece of work, having no tool but a clumsy screw-driver for
taking to pieces and putting together again the complicated
mechanism of the instantaneous shutter, is still a mystery to me; but
he did it successfully. The loss of his finger-nails shows him in a light
contrasting curiously enough with the intelligence evinced by the
above operation; though, after all, it is scarcely surprising after his
ten years’ residence in the bush. One day, at Lindi, he had occasion
to wash a dog, which must have been in need of very thorough
cleansing, for the bottle handed to our friend for the purpose had an
extremely strong smell. Having performed his task in the most
conscientious manner, he perceived with some surprise that the dog
did not appear much the better for it, and was further surprised by
finding his own nails ulcerating away in the course of the next few
days. “How was I to know that carbolic acid has to be diluted?” he
mutters indignantly, from time to time, with a troubled gaze at his
mutilated finger-tips.
Since we came to Newala we have been making excursions in all
directions through the surrounding country, in accordance with old
habit, and also because the akida Sefu did not get together the tribal
elders from whom I wanted information so speedily as he had
promised. There is, however, no harm done, as, even if seen only
from the outside, the country and people are interesting enough.
The Makonde plateau is like a large rectangular table rounded off
at the corners. Measured from the Indian Ocean to Newala, it is
about seventy-five miles long, and between the Rovuma and the
Lukuledi it averages fifty miles in breadth, so that its superficial area
is about two-thirds of that of the kingdom of Saxony. The surface,
however, is not level, but uniformly inclined from its south-western
edge to the ocean. From the upper edge, on which Newala lies, the
eye ranges for many miles east and north-east, without encountering
any obstacle, over the Makonde bush. It is a green sea, from which
here and there thick clouds of smoke rise, to show that it, too, is
inhabited by men who carry on their tillage like so many other
primitive peoples, by cutting down and burning the bush, and
manuring with the ashes. Even in the radiant light of a tropical day
such a fire is a grand sight.
Much less effective is the impression produced just now by the
great western plain as seen from the edge of the plateau. As often as
time permits, I stroll along this edge, sometimes in one direction,
sometimes in another, in the hope of finding the air clear enough to
let me enjoy the view; but I have always been disappointed.
Wherever one looks, clouds of smoke rise from the burning bush,
and the air is full of smoke and vapour. It is a pity, for under more
favourable circumstances the panorama of the whole country up to
the distant Majeje hills must be truly magnificent. It is of little use
taking photographs now, and an outline sketch gives a very poor idea
of the scenery. In one of these excursions I went out of my way to
make a personal attempt on the Makonde bush. The present edge of
the plateau is the result of a far-reaching process of destruction
through erosion and denudation. The Makonde strata are
everywhere cut into by ravines, which, though short, are hundreds of
yards in depth. In consequence of the loose stratification of these
beds, not only are the walls of these ravines nearly vertical, but their
upper end is closed by an equally steep escarpment, so that the
western edge of the Makonde plateau is hemmed in by a series of
deep, basin-like valleys. In order to get from one side of such a ravine
to the other, I cut my way through the bush with a dozen of my men.
It was a very open part, with more grass than scrub, but even so the
short stretch of less than two hundred yards was very hard work; at
the end of it the men’s calicoes were in rags and they themselves
bleeding from hundreds of scratches, while even our strong khaki
suits had not escaped scatheless.
NATIVE PATH THROUGH THE MAKONDE BUSH, NEAR

MAHUTA
I see increasing reason to believe that the view formed some time
back as to the origin of the Makonde bush is the correct one. I have
no doubt that it is not a natural product, but the result of human
occupation. Those parts of the high country where man—as a very
slight amount of practice enables the eye to perceive at once—has not
yet penetrated with axe and hoe, are still occupied by a splendid
timber forest quite able to sustain a comparison with our mixed
forests in Germany. But wherever man has once built his hut or tilled
his field, this horrible bush springs up. Every phase of this process
may be seen in the course of a couple of hours’ walk along the main
road. From the bush to right or left, one hears the sound of the axe—
not from one spot only, but from several directions at once. A few
steps further on, we can see what is taking place. The brush has been
cut down and piled up in heaps to the height of a yard or more,
between which the trunks of the large trees stand up like the last
pillars of a magnificent ruined building. These, too, present a
melancholy spectacle: the destructive Makonde have ringed them—
cut a broad strip of bark all round to ensure their dying off—and also
piled up pyramids of brush round them. Father and son, mother and
son-in-law, are chopping away perseveringly in the background—too
busy, almost, to look round at the white stranger, who usually excites
so much interest. If you pass by the same place a week later, the piles
of brushwood have disappeared and a thick layer of ashes has taken
the place of the green forest. The large trees stretch their
smouldering trunks and branches in dumb accusation to heaven—if
they have not already fallen and been more or less reduced to ashes,
perhaps only showing as a white stripe on the dark ground.
This work of destruction is carried out by the Makonde alike on the
virgin forest and on the bush which has sprung up on sites already
cultivated and deserted. In the second case they are saved the trouble
of burning the large trees, these being entirely absent in the
secondary bush.
After burning this piece of forest ground and loosening it with the
hoe, the native sows his corn and plants his vegetables. All over the
country, he goes in for bed-culture, which requires, and, in fact,
receives, the most careful attention. Weeds are nowhere tolerated in
the south of German East Africa. The crops may fail on the plains,
where droughts are frequent, but never on the plateau with its
abundant rains and heavy dews. Its fortunate inhabitants even have
the satisfaction of seeing the proud Wayao and Wamakua working
for them as labourers, driven by hunger to serve where they were
accustomed to rule.
But the light, sandy soil is soon exhausted, and would yield no
harvest the second year if cultivated twice running. This fact has
been familiar to the native for ages; consequently he provides in
time, and, while his crop is growing, prepares the next plot with axe
and firebrand. Next year he plants this with his various crops and
lets the first piece lie fallow. For a short time it remains waste and
desolate; then nature steps in to repair the destruction wrought by
man; a thousand new growths spring out of the exhausted soil, and
even the old stumps put forth fresh shoots. Next year the new growth
is up to one’s knees, and in a few years more it is that terrible,
impenetrable bush, which maintains its position till the black
occupier of the land has made the round of all the available sites and
come back to his starting point.
The Makonde are, body and soul, so to speak, one with this bush.
According to my Yao informants, indeed, their name means nothing
else but “bush people.” Their own tradition says that they have been
settled up here for a very long time, but to my surprise they laid great
stress on an original immigration. Their old homes were in the
south-east, near Mikindani and the mouth of the Rovuma, whence
their peaceful forefathers were driven by the continual raids of the
Sakalavas from Madagascar and the warlike Shirazis[47] of the coast,
to take refuge on the almost inaccessible plateau. I have studied
African ethnology for twenty years, but the fact that changes of
population in this apparently quiet and peaceable corner of the earth
could have been occasioned by outside enterprises taking place on
the high seas, was completely new to me. It is, no doubt, however,
correct.
The charming tribal legend of the Makonde—besides informing us
of other interesting matters—explains why they have to live in the
thickest of the bush and a long way from the edge of the plateau,
instead of making their permanent homes beside the purling brooks
and springs of the low country.
“The place where the tribe originated is Mahuta, on the southern
side of the plateau towards the Rovuma, where of old time there was
nothing but thick bush. Out of this bush came a man who never
washed himself or shaved his head, and who ate and drank but little.
He went out and made a human figure from the wood of a tree
growing in the open country, which he took home to his abode in the
bush and there set it upright. In the night this image came to life and
was a woman. The man and woman went down together to the
Rovuma to wash themselves. Here the woman gave birth to a still-
born child. They left that place and passed over the high land into the
valley of the Mbemkuru, where the woman had another child, which
was also born dead. Then they returned to the high bush country of
Mahuta, where the third child was born, which lived and grew up. In
course of time, the couple had many more children, and called
themselves Wamatanda. These were the ancestral stock of the
Makonde, also called Wamakonde,[48] i.e., aborigines. Their
forefather, the man from the bush, gave his children the command to
bury their dead upright, in memory of the mother of their race who
was cut out of wood and awoke to life when standing upright. He also
warned them against settling in the valleys and near large streams,
for sickness and death dwelt there. They were to make it a rule to
have their huts at least an hour’s walk from the nearest watering-
place; then their children would thrive and escape illness.”
The explanation of the name Makonde given by my informants is
somewhat different from that contained in the above legend, which I
extract from a little book (small, but packed with information), by
Pater Adams, entitled Lindi und sein Hinterland. Otherwise, my
results agree exactly with the statements of the legend. Washing?
Hapana—there is no such thing. Why should they do so? As it is, the
supply of water scarcely suffices for cooking and drinking; other
people do not wash, so why should the Makonde distinguish himself
by such needless eccentricity? As for shaving the head, the short,
woolly crop scarcely needs it,[49] so the second ancestral precept is
likewise easy enough to follow. Beyond this, however, there is
nothing ridiculous in the ancestor’s advice. I have obtained from
various local artists a fairly large number of figures carved in wood,
ranging from fifteen to twenty-three inches in height, and
representing women belonging to the great group of the Mavia,
Makonde, and Matambwe tribes. The carving is remarkably well
done and renders the female type with great accuracy, especially the
keloid ornamentation, to be described later on. As to the object and
meaning of their works the sculptors either could or (more probably)
would tell me nothing, and I was forced to content myself with the
scanty information vouchsafed by one man, who said that the figures
were merely intended to represent the nembo—the artificial
deformations of pelele, ear-discs, and keloids. The legend recorded
by Pater Adams places these figures in a new light. They must surely
be more than mere dolls; and we may even venture to assume that
they are—though the majority of present-day Makonde are probably
unaware of the fact—representations of the tribal ancestress.
The references in the legend to the descent from Mahuta to the
Rovuma, and to a journey across the highlands into the Mbekuru
valley, undoubtedly indicate the previous history of the tribe, the
travels of the ancestral pair typifying the migrations of their
descendants. The descent to the neighbouring Rovuma valley, with
its extraordinary fertility and great abundance of game, is intelligible
at a glance—but the crossing of the Lukuledi depression, the ascent
to the Rondo Plateau and the descent to the Mbemkuru, also lie
within the bounds of probability, for all these districts have exactly
the same character as the extreme south. Now, however, comes a
point of especial interest for our bacteriological age. The primitive
Makonde did not enjoy their lives in the marshy river-valleys.
Disease raged among them, and many died. It was only after they
had returned to their original home near Mahuta, that the health
conditions of these people improved. We are very apt to think of the
African as a stupid person whose ignorance of nature is only equalled
by his fear of it, and who looks on all mishaps as caused by evil
spirits and malignant natural powers. It is much more correct to
assume in this case that the people very early learnt to distinguish
districts infested with malaria from those where it is absent.
This knowledge is crystallized in the
ancestral warning against settling in the
valleys and near the great waters, the
dwelling-places of disease and death. At the
same time, for security against the hostile
Mavia south of the Rovuma, it was enacted
that every settlement must be not less than a
certain distance from the southern edge of the
plateau. Such in fact is their mode of life at the
present day. It is not such a bad one, and
certainly they are both safer and more
comfortable than the Makua, the recent
intruders from the south, who have made USUAL METHOD OF
good their footing on the western edge of the CLOSING HUT-DOOR
plateau, extending over a fairly wide belt of
country. Neither Makua nor Makonde show in their dwellings
anything of the size and comeliness of the Yao houses in the plain,
especially at Masasi, Chingulungulu and Zuza’s. Jumbe Chauro, a
Makonde hamlet not far from Newala, on the road to Mahuta, is the
most important settlement of the tribe I have yet seen, and has fairly
spacious huts. But how slovenly is their construction compared with
the palatial residences of the elephant-hunters living in the plain.
The roofs are still more untidy than in the general run of huts during
the dry season, the walls show here and there the scanty beginnings
or the lamentable remains of the mud plastering, and the interior is a
veritable dog-kennel; dirt, dust and disorder everywhere. A few huts
only show any attempt at division into rooms, and this consists
merely of very roughly-made bamboo partitions. In one point alone
have I noticed any indication of progress—in the method of fastening
the door. Houses all over the south are secured in a simple but
ingenious manner. The door consists of a set of stout pieces of wood
or bamboo, tied with bark-string to two cross-pieces, and moving in
two grooves round one of the door-posts, so as to open inwards. If
the owner wishes to leave home, he takes two logs as thick as a man’s
upper arm and about a yard long. One of these is placed obliquely
against the middle of the door from the inside, so as to form an angle
of from 60° to 75° with the ground. He then places the second piece
horizontally across the first, pressing it downward with all his might.
It is kept in place by two strong posts planted in the ground a few
inches inside the door. This fastening is absolutely safe, but of course
cannot be applied to both doors at once, otherwise how could the
owner leave or enter his house? I have not yet succeeded in finding
out how the back door is fastened.
MAKONDE LOCK AND KEY AT JUMBE CHAURO

This is the general way of closing a house. The Makonde at Jumbe
Chauro, however, have a much more complicated, solid and original
one. Here, too, the door is as already described, except that there is
only one post on the inside, standing by itself about six inches from
one side of the doorway. Opposite this post is a hole in the wall just
large enough to admit a man’s arm. The door is closed inside by a
large wooden bolt passing through a hole in this post and pressing
with its free end against the door. The other end has three holes into
which fit three pegs running in vertical grooves inside the post. The
door is opened with a wooden key about a foot long, somewhat
curved and sloped off at the butt; the other end has three pegs
corresponding to the holes, in the bolt, so that, when it is thrust
through the hole in the wall and inserted into the rectangular
opening in the post, the pegs can be lifted and the bolt drawn out.[50]
MODE OF INSERTING THE KEY
With no small pride first one householder and then a second

showed me on the spot the action of this greatest invention of the
Makonde Highlands. To both with an admiring exclamation of
“Vizuri sana!” (“Very fine!”). I expressed the wish to take back these
marvels with me to Ulaya, to show the Wazungu what clever fellows
the Makonde are. Scarcely five minutes after my return to camp at
Newala, the two men came up sweating under the weight of two
heavy logs which they laid down at my feet, handing over at the same
time the keys of the fallen fortress. Arguing, logically enough, that if
the key was wanted, the lock would be wanted with it, they had taken
their axes and chopped down the posts—as it never occurred to them
to dig them out of the ground and so bring them intact. Thus I have
two badly damaged specimens, and the owners, instead of praise,
come in for a blowing-up.
The Makua huts in the environs of Newala are especially
miserable; their more than slovenly construction reminds one of the
temporary erections of the Makua at Hatia’s, though the people here
have not been concerned in a war. It must therefore be due to
congenital idleness, or else to the absence of a powerful chief. Even
the baraza at Mlipa’s, a short hour’s walk south-east of Newala,
shares in this general neglect. While public buildings in this country
are usually looked after more or less carefully, this is in evident
danger of being blown over by the first strong easterly gale. The only
attractive object in this whole district is the grave of the late chief
Mlipa. I visited it in the morning, while the sun was still trying with
partial success to break through the rolling mists, and the circular
grove of tall euphorbias, which, with a broken pot, is all that marks
the old king’s resting-place, impressed one with a touch of pathos.
Even my very materially-minded carriers seemed to feel something
of the sort, for instead of their usual ribald songs, they chanted
solemnly, as we marched on through the dense green of the Makonde
bush:—
“We shall arrive with the great master; we stand in a row and have
no fear about getting our food and our money from the Serkali (the
Government). We are not afraid; we are going along with the great
master, the lion; we are going down to the coast and back.”
With regard to the characteristic features of the various tribes here
on the western edge of the plateau, I can arrive at no other
conclusion than the one already come to in the plain, viz., that it is
impossible for anyone but a trained anthropologist to assign any
given individual at once to his proper tribe. In fact, I think that even
an anthropological specialist, after the most careful examination,
might find it a difficult task to decide. The whole congeries of peoples
collected in the region bounded on the west by the great Central
African rift, Tanganyika and Nyasa, and on the east by the Indian
Ocean, are closely related to each other—some of their languages are
only distinguished from one another as dialects of the same speech,
and no doubt all the tribes present the same shape of skull and
structure of skeleton. Thus, surely, there can be no very striking
differences in outward appearance.
Even did such exist, I should have no time
to concern myself with them, for day after day,
I have to see or hear, as the case may be—in
any case to grasp and record—an
extraordinary number of ethnographic
phenomena. I am almost disposed to think it
fortunate that some departments of inquiry, at
least, are barred by external circumstances.
Chief among these is the subject of iron-
working. We are apt to think of Africa as a
country where iron ore is everywhere, so to
speak, to be picked up by the roadside, and
where it would be quite surprising if the
inhabitants had not learnt to smelt the
material ready to their hand. In fact, the
knowledge of this art ranges all over the
continent, from the Kabyles in the north to the
Kafirs in the south. Here between the Rovuma
and the Lukuledi the conditions are not so
favourable. According to the statements of the
Makonde, neither ironstone nor any other
form of iron ore is known to them. They have
not therefore advanced to the art of smelting
the metal, but have hitherto bought all their
THE ANCESTRESS OF
THE MAKONDE
iron implements from neighbouring tribes.
Even in the plain the inhabitants are not much
better off. Only one man now living is said to
understand the art of smelting iron. This old fundi lives close to
Huwe, that isolated, steep-sided block of granite which rises out of
the green solitude between Masasi and Chingulungulu, and whose
jagged and splintered top meets the traveller’s eye everywhere. While
still at Masasi I wished to see this man at work, but was told that,
frightened by the rising, he had retired across the Rovuma, though
he would soon return. All subsequent inquiries as to whether the
fundi had come back met with the genuine African answer, “Bado”
(“Not yet”).
BRAZIER
Some consolation was afforded me by a brassfounder, whom I

came across in the bush near Akundonde’s. This man is the favourite
of women, and therefore no doubt of the gods; he welds the glittering
brass rods purchased at the coast into those massive, heavy rings
which, on the wrists and ankles of the local fair ones, continually give
me fresh food for admiration. Like every decent master-craftsman he
had all his tools with him, consisting of a pair of bellows, three
crucibles and a hammer—nothing more, apparently. He was quite
willing to show his skill, and in a twinkling had fixed his bellows on
the ground. They are simply two goat-skins, taken off whole, the four
legs being closed by knots, while the upper opening, intended to
admit the air, is kept stretched by two pieces of wood. At the lower
end of the skin a smaller opening is left into which a wooden tube is
stuck. The fundi has quickly borrowed a heap of wood-embers from
the nearest hut; he then fixes the free ends of the two tubes into an
earthen pipe, and clamps them to the ground by means of a bent
piece of wood. Now he fills one of his small clay crucibles, the dross
on which shows that they have been long in use, with the yellow
material, places it in the midst of the embers, which, at present are
only faintly glimmering, and begins his work. In quick alternation
the smith’s two hands move up and down with the open ends of the
bellows; as he raises his hand he holds the slit wide open, so as to let
the air enter the skin bag unhindered. In pressing it down he closes
the bag, and the air puffs through the bamboo tube and clay pipe into
the fire, which quickly burns up. The smith, however, does not keep
on with this work, but beckons to another man, who relieves him at
the bellows, while he takes some more tools out of a large skin pouch
carried on his back. I look on in wonder as, with a smooth round
stick about the thickness of a finger, he bores a few vertical holes into
the clean sand of the soil. This should not be difficult, yet the man
seems to be taking great pains over it. Then he fastens down to the
ground, with a couple of wooden clamps, a neat little trough made by
splitting a joint of bamboo in half, so that the ends are closed by the
two knots. At last the yellow metal has attained the right consistency,
and the fundi lifts the crucible from the fire by means of two sticks
split at the end to serve as tongs. A short swift turn to the left—a
tilting of the crucible—and the molten brass, hissing and giving forth
clouds of smoke, flows first into the bamboo mould and then into the
holes in the ground.
The technique of this backwoods craftsman may not be very far
advanced, but it cannot be denied that he knows how to obtain an
adequate result by the simplest means. The ladies of highest rank in
this country—that is to say, those who can afford it, wear two kinds
of these massive brass rings, one cylindrical, the other semicircular
in section. The latter are cast in the most ingenious way in the
bamboo mould, the former in the circular hole in the sand. It is quite
a simple matter for the fundi to fit these bars to the limbs of his fair
customers; with a few light strokes of his hammer he bends the
pliable brass round arm or ankle without further inconvenience to
the wearer.
SHAPING THE POT
SMOOTHING WITH MAIZE-COB
CUTTING THE EDGE

FINISHING THE BOTTOM
LAST SMOOTHING BEFORE

BURNING
FIRING THE BRUSH-PILE

LIGHTING THE FARTHER SIDE OF
THE PILE
TURNING THE RED-HOT VESSEL
NYASA WOMAN MAKING POTS AT MASASI

Pottery is an art which must always and everywhere excite the
interest of the student, just because it is so intimately connected with
the development of human culture, and because its relics are one of
the principal factors in the reconstruction of our own condition in
prehistoric times. I shall always remember with pleasure the two or
three afternoons at Masasi when Salim Matola’s mother, a slightly-
built, graceful, pleasant-looking woman, explained to me with
touching patience, by means of concrete illustrations, the ceramic art
of her people. The only implements for this primitive process were a
lump of clay in her left hand, and in the right a calabash containing
the following valuables: the fragment of a maize-cob stripped of all
its grains, a smooth, oval pebble, about the size of a pigeon’s egg, a
few chips of gourd-shell, a bamboo splinter about the length of one’s
hand, a small shell, and a bunch of some herb resembling spinach.
Nothing more. The woman scraped with the
shell a round, shallow hole in the soft, fine
sand of the soil, and, when an active young
girl had filled the calabash with water for her,
she began to knead the clay. As if by magic it
gradually assumed the shape of a rough but
already well-shaped vessel, which only wanted
a little touching up with the instruments
before mentioned. I looked out with the
MAKUA WOMAN closest attention for any indication of the use
MAKING A POT. of the potter’s wheel, in however rudimentary
SHOWS THE a form, but no—hapana (there is none). The
BEGINNINGS OF THE embryo pot stood firmly in its little
POTTER’S WHEEL
depression, and the woman walked round it in
a stooping posture, whether she was removing
small stones or similar foreign bodies with the maize-cob, smoothing
the inner or outer surface with the splinter of bamboo, or later, after
letting it dry for a day, pricking in the ornamentation with a pointed
bit of gourd-shell, or working out the bottom, or cutting the edge
with a sharp bamboo knife, or giving the last touches to the finished
vessel. This occupation of the women is infinitely toilsome, but it is
without doubt an accurate reproduction of the process in use among
our ancestors of the Neolithic and Bronze ages.
There is no doubt that the invention of pottery, an item in human
progress whose importance cannot be over-estimated, is due to
women. Rough, coarse and unfeeling, the men of the horde range
over the countryside. When the united cunning of the hunters has
succeeded in killing the game; not one of them thinks of carrying
home the spoil. A bright fire, kindled by a vigorous wielding of the
drill, is crackling beside them; the animal has been cleaned and cut
up secundum artem, and, after a slight singeing, will soon disappear
under their sharp teeth; no one all this time giving a single thought
to wife or child.
To what shifts, on the other hand, the primitive wife, and still more
the primitive mother, was put! Not even prehistoric stomachs could
endure an unvarying diet of raw food. Something or other suggested
the beneficial effect of hot water on the majority of approved but
indigestible dishes. Perhaps a neighbour had tried holding the hard
roots or tubers over the fire in a calabash filled with water—or maybe
an ostrich-egg-shell, or a hastily improvised vessel of bark. They
became much softer and more palatable than they had previously
been; but, unfortunately, the vessel could not stand the fire and got
charred on the outside. That can be remedied, thought our
ancestress, and plastered a layer of wet clay round a similar vessel.
This is an improvement; the cooking utensil remains uninjured, but
the heat of the fire has shrunk it, so that it is loose in its shell. The
next step is to detach it, so, with a firm grip and a jerk, shell and
kernel are separated, and pottery is invented. Perhaps, however, the
discovery which led to an intelligent use of the burnt-clay shell, was
made in a slightly different way. Ostrich-eggs and calabashes are not
to be found in every part of the world, but everywhere mankind has
arrived at the art of making baskets out of pliant materials, such as
bark, bast, strips of palm-leaf, supple twigs, etc. Our inventor has no
water-tight vessel provided by nature. “Never mind, let us line the
basket with clay.” This answers the purpose, but alas! the basket gets
burnt over the blazing fire, the woman watches the process of
cooking with increasing uneasiness, fearing a leak, but no leak
appears. The food, done to a turn, is eaten with peculiar relish; and
the cooking-vessel is examined, half in curiosity, half in satisfaction
at the result. The plastic clay is now hard as stone, and at the same
time looks exceedingly well, for the neat plaiting of the burnt basket
is traced all over it in a pretty pattern. Thus, simultaneously with
pottery, its ornamentation was invented.
Primitive woman has another claim to respect. It was the man,
roving abroad, who invented the art of producing fire at will, but the
woman, unable to imitate him in this, has been a Vestal from the
earliest times. Nothing gives so much trouble as the keeping alight of
the smouldering brand, and, above all, when all the men are absent
from the camp. Heavy rain-clouds gather, already the first large
drops are falling, the first gusts of the storm rage over the plain. The
little flame, a greater anxiety to the woman than her own children,
flickers unsteadily in the blast. What is to be done? A sudden thought
occurs to her, and in an instant she has constructed a primitive hut
out of strips of bark, to protect the flame against rain and wind.
This, or something very like it, was the way in which the principle
of the house was discovered; and even the most hardened misogynist
cannot fairly refuse a woman the credit of it. The protection of the
hearth-fire from the weather is the germ from which the human
dwelling was evolved. Men had little, if any share, in this forward
step, and that only at a late stage. Even at the present day, the
plastering of the housewall with clay and the manufacture of pottery
are exclusively the women’s business. These are two very significant
survivals. Our European kitchen-garden, too, is originally a woman’s
invention, and the hoe, the primitive instrument of agriculture, is,
characteristically enough, still used in this department. But the
noblest achievement which we owe to the other sex is unquestionably
the art of cookery. Roasting alone—the oldest process—is one for
which men took the hint (a very obvious one) from nature. It must
have been suggested by the scorched carcase of some animal
overtaken by the destructive forest-fires. But boiling—the process of
improving organic substances by the help of water heated to boiling-
point—is a much later discovery. It is so recent that it has not even
yet penetrated to all parts of the world. The Polynesians understand
how to steam food, that is, to cook it, neatly wrapped in leaves, in a
hole in the earth between hot stones, the air being excluded, and
(sometimes) a few drops of water sprinkled on the stones; but they
do not understand boiling.
To come back from this digression, we find that the slender Nyasa
woman has, after once more carefully examining the finished pot,
put it aside in the shade to dry. On the following day she sends me
word by her son, Salim Matola, who is always on hand, that she is
going to do the burning, and, on coming out of my house, I find her
already hard at work. She has spread on the ground a layer of very
dry sticks, about as thick as one’s thumb, has laid the pot (now of a
yellowish-grey colour) on them, and is piling brushwood round it.
My faithful Pesa mbili, the mnyampara, who has been standing by,
most obligingly, with a lighted stick, now hands it to her. Both of
them, blowing steadily, light the pile on the lee side, and, when the
flame begins to catch, on the weather side also. Soon the whole is in a
blaze, but the dry fuel is quickly consumed and the fire dies down, so
that we see the red-hot vessel rising from the ashes. The woman
turns it continually with a long stick, sometimes one way and
sometimes another, so that it may be evenly heated all over. In
twenty minutes she rolls it out of the ash-heap, takes up the bundle
of spinach, which has been lying for two days in a jar of water, and
sprinkles the red-hot clay with it. The places where the drops fall are
marked by black spots on the uniform reddish-brown surface. With a
sigh of relief, and with visible satisfaction, the woman rises to an
erect position; she is standing just in a line between me and the fire,
from which a cloud of smoke is just rising: I press the ball of my
camera, the shutter clicks—the apotheosis is achieved! Like a
priestess, representative of her inventive sex, the graceful woman
stands: at her feet the hearth-fire she has given us beside her the
invention she has devised for us, in the background the home she has
built for us.
At Newala, also, I have had the manufacture of pottery carried on
in my presence. Technically the process is better than that already
described, for here we find the beginnings of the potter’s wheel,
which does not seem to exist in the plains; at least I have seen
nothing of the sort. The artist, a frightfully stupid Makua woman, did
not make a depression in the ground to receive the pot she was about
to shape, but used instead a large potsherd. Otherwise, she went to
work in much the same way as Salim’s mother, except that she saved
herself the trouble of walking round and round her work by squatting
at her ease and letting the pot and potsherd rotate round her; this is
surely the first step towards a machine. But it does not follow that
the pot was improved by the process. It is true that it was beautifully
rounded and presented a very creditable appearance when finished,
but the numerous large and small vessels which I have seen, and, in
part, collected, in the “less advanced” districts, are no less so. We
moderns imagine that instruments of precision are necessary to
produce excellent results. Go to the prehistoric collections of our
museums and look at the pots, urns and bowls of our ancestors in the
dim ages of the past, and you will at once perceive your error.
MAKING LONGITUDINAL CUT IN
BARK
DRAWING THE BARK OFF THE LOG
REMOVING THE OUTER BARK

BEATING THE BARK
WORKING THE BARK-CLOTH AFTER BEATING, TO MAKE IT

SOFT
MANUFACTURE OF BARK-CLOTH AT NEWALA

To-day, nearly the whole population of German East Africa is
clothed in imported calico. This was not always the case; even now in
some parts of the north dressed skins are still the prevailing wear,
and in the north-western districts—east and north of Lake
Tanganyika—lies a zone where bark-cloth has not yet been
superseded. Probably not many generations have passed since such
bark fabrics and kilts of skins were the only clothing even in the
south. Even to-day, large quantities of this bright-red or drab
material are still to be found; but if we wish to see it, we must look in
the granaries and on the drying stages inside the native huts, where
it serves less ambitious uses as wrappings for those seeds and fruits
which require to be packed with special care. The salt produced at
Masasi, too, is packed for transport to a distance in large sheets of
bark-cloth. Wherever I found it in any degree possible, I studied the
process of making this cloth. The native requisitioned for the
purpose arrived, carrying a log between two and three yards long and
as thick as his thigh, and nothing else except a curiously-shaped
mallet and the usual long, sharp and pointed knife which all men and
boys wear in a belt at their backs without a sheath—horribile dictu!
[51]
Silently he squats down before me, and with two rapid cuts has
drawn a couple of circles round the log some two yards apart, and
slits the bark lengthwise between them with the point of his knife.
With evident care, he then scrapes off the outer rind all round the
log, so that in a quarter of an hour the inner red layer of the bark
shows up brightly-coloured between the two untouched ends. With
some trouble and much caution, he now loosens the bark at one end,
and opens the cylinder. He then stands up, takes hold of the free
edge with both hands, and turning it inside out, slowly but steadily
pulls it off in one piece. Now comes the troublesome work of
scraping all superfluous particles of outer bark from the outside of
the long, narrow piece of material, while the inner side is carefully
scrutinised for defective spots. At last it is ready for beating. Having
signalled to a friend, who immediately places a bowl of water beside
him, the artificer damps his sheet of bark all over, seizes his mallet,
lays one end of the stuff on the smoothest spot of the log, and
hammers away slowly but continuously. “Very simple!” I think to
myself. “Why, I could do that, too!”—but I am forced to change my
opinions a little later on; for the beating is quite an art, if the fabric is
not to be beaten to pieces. To prevent the breaking of the fibres, the
stuff is several times folded across, so as to interpose several
thicknesses between the mallet and the block. At last the required
state is reached, and the fundi seizes the sheet, still folded, by both
ends, and wrings it out, or calls an assistant to take one end while he
holds the other. The cloth produced in this way is not nearly so fine
and uniform in texture as the famous Uganda bark-cloth, but it is
quite soft, and, above all, cheap.
Now, too, I examine the mallet. My craftsman has been using the
simpler but better form of this implement, a conical block of some
hard wood, its base—the striking surface—being scored across and
across with more or less deeply-cut grooves, and the handle stuck
into a hole in the middle. The other and earlier form of mallet is
shaped in the same way, but the head is fastened by an ingenious
network of bark strips into the split bamboo serving as a handle. The
observation so often made, that ancient customs persist longest in
connection with religious ceremonies and in the life of children, here
finds confirmation. As we shall soon see, bark-cloth is still worn
during the unyago,[52] having been prepared with special solemn
ceremonies; and many a mother, if she has no other garment handy,
will still put her little one into a kilt of bark-cloth, which, after all,
looks better, besides being more in keeping with its African
surroundings, than the ridiculous bit of print from Ulaya.
MAKUA WOMEN

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BUSINESS FINANCE FIRST EDITION

ABOUT THE AUTHORS x

Balance between conceptual understanding and

A focus on value creation

Integrated approach: intuition, analysis and decision making

Basic concepts and tools

1 The financial manager and the company

2 The financial environment and the level of interest rates

3 The time value of money

4 Discounted cash flows and valuation

5 Risk and return

6 Bond valuation and the structure of interest rates

8 The fundamentals of capital budgeting

9 Cash flows and capital budgeting

10 Evaluating project economics and capital rationing

12 Working capital management

13 How companies raise capital

14 Capital structure policy

15 Dividends and dividend policy

Chapter scene setter

demONstratION prOBLem 10.1

Demonstration problem Along with a

quantitative problems with step-by-step

solutions to help students better understand

skills to solve important problems. By

students with additional practice in the

application of the concepts, tools and EBIT $2000

c10EvaluatingProjectEconomicsAndCapitalRationing 345 14 December 2015 6:19 PM

demONstratION prOBLem 10.1

c10EvaluatingProjectEconomicsAndCapitalRationing 361 13 January 2016 6:27 PM

Chapter 10 Evaluating project economics and capital rationing 345

xvii HOW TO USE THIS RESOURCE

12.1 Operating cycle Operating cycle = DSO + DSI

12.4 Effective annual rate (EAR)  Discount 

SELF-STUDy PROBLEMS Self-study problems Five problems similar

CRITICAL THINKING QUESTIONS

Chapter 12 Working capital management 435

c12WorkingCapitalManagement 435 15 December 2015 7:20 PM

Critical thinking questions At least CRITICAL THINKING qUESTIONS

think through their understanding of key feature?

Questions and problems The questions qUESTIONS AND PROBLEMS

Chapter 6 Bond valuation and the structure of interest rates 217

c06BondValuationAndTheStructureOfInterestRates 217 27 November 2015 7:19 AM

HOW TO USE THIS RESOURCE xviii

xx SELECTED ABBREVIATIONS AND NOTATION

2 The financial environment and the level of interest rates 28

The financial manager

After studying this chapter, you should be able to:

CHAPTER 1 The financial manager and the company 3

1.1 The role of the financial manager

It’s all about cash flows

Productive assets Cash paid

Cash flow reinvested Dividends paid to

CHAPTER 1 The financial manager and the company 5

Cash flows matter most to investors

Three fundamental decisions in financial management

Assets Liabilities and equity

CHAPTER 1 The financial manager and the company 7

Financing decisions affect the value of the company

Working capital management decisions

1.2 Forms of business organisation