Our final chapter presents a review, after which the reader can determine whether the book accomplished the goals we promised in Chapter 1.

This book presents the basic tools for understanding (and hopefully doing) finance. We introduced the reader to corporate finance by noting its primary functions are summarized by three main tasks:

1. How to make good investment decisions
2. How to make good financing decisions
3. How to manage the firm’s cash flows while doing the first two

We noted that cash flow is like air, and earnings are like food. An organization needs both to survive, but although a firm can exist for a while without earnings, it will die quickly without cash. A firm must ensure that it does not run out of cash. We next defined making good investment decisions as deciding where the firm should put (invest) its cash, that is, what projects/products to invest in and produce. Finally, we said making good financing decisions means deciding where the firm should obtain the cash for its investments.

Importantly, financial strategy and business strategy need to be consistent. We explained that each firm operates in two primary markets—the product market and the financial market—and that you can’t do corporate finance properly without also understanding the product market in which a firm operates. Thus, when thinking about corporate finance, a firm must first determine its product market goals. Only then, once the product market goals are set, can management set its financial strategy and determine its financial policies.

The above points reflect how your authors approach corporate finance. We believe you should start with a firm’s product market and from that decide on a corporate strategy. This will lead to the setting of corporate product market goals. Only after that is done can a firm then define its financial strategy, both on the investment side and the financing side.

Financial policies that are consistent with the financial strategy are then set and implemented. The policies include whether a firm should grow internally or by merger, how a firm should choose its capital structure, whether its debt is short-term or long-term, whether the debt is secured or unsecured, whether the interest rate on the debt is fixed or floating, what the dividend policy will be, and so on.

All these policies have implications for the firm, and the market reacts to changes in financial policies by changing firm value, often very quickly.

Chapters 2–4: Cash Flow Management—Financial Tools

We began this book with our plumbing supply store, PIPES, in Chapter 2. We looked at financial ratios and sources and uses of funds as diagnostics. We demonstrated that there are numerous ways to compute ratios, showed how various ratios relate to each other, and offered an explanation of their basic purpose. We stated that ratios are the place to start any corporate finance analysis. They provide diagnostics of the firm’s health, much as your blood pressure, temperature, and pulse rate do for you. Ratios are tools that are used to evaluate a firm against other firms in the industry and against itself over time. Analyzing the Sources and Uses helps determine where a firm is receiving its cash flow from and what it is investing its cash flow in. This also provides a diagnostic indicator of what parts of the firm’s operations need to be explored in more detail.

Chapter 3 added the financial tool of pro forma analysis and then used it to forecast future financial needs, both in amount as well as timing. A road map of how to create pro forma Income Statements and Balance Sheets was provided. While there are numerous ways to prepare pro formas (i.e., forecasts), we used percentage of sales, noting that this is how pro formas are normally done unless there is a reason to use another method. Pro formas can also provide a diagnostic analysis when they are used to compare forecasts to actuals. Pro formas are regularly used to determine what the firm’s financing needs are, which helps prevent it from running out of cash. Finally, pro formas are used to forecast the firm’s cash flows, which is essential in evaluating whether investments are good or not. Scenario and sensitivity analysis using pro formas then allows for an assessment of different possible outcomes (e.g., best and worst case).

Chapter 4 extended the discussion of pro forma analysis and examined the impact of seasonality on a firm’s financial statements. If a firm’s activities are fairly constant throughout the year, it is sufficient to use a firm’s annual financial statements for the diagnostics. However, if a firm’s activities fluctuate (have significant variations) over the year, the impact of these fluctuations must be estimated in order to properly determine a firm’s financing requirements. For example, the Christmas season typically comprises much higher sales than other parts of the year for U.S. retailers. This impacts the firm’s inventory, receivables, and debt.

These basic financial tools are the building blocks for determining the firm’s financing needs, its financial policies, and which investments it should undertake. Past ratios are used to predict future Income Statements and Balance Sheets. These pro forma financial statements help predict the size of a firm’s financing needs and the length of time needed. The pro formas also are used to estimate future cash flows, which helps determine whether a project will have a positive NPV or not.

Chapters 5–12: Financing Decisions and Financial Policies

We next asked: Where does a firm get its cash flow? The answer was from one of two places, internally or externally. Understanding internal cash flows means understanding sustainable growth, which uses the DuPont formula for ROE (profitability times capital intensity times leverage):

Sustainable growth states that if all else is constant (i.e., the ratios in the DuPont formula stay constant), a firm can grow internally at the ROE times 1 minus the dividend payout ratio. (Note: When we first presented this concept early in the book, we called it “shelling the beaches.” That was our way of saying that we would be returning to this point later. Our intent was for this book to repeat all important concepts many times. At this point, hopefully, our strategy is obvious and worked.)

External financing is required when the firm can’t generate sufficient funds internally. This is when a firm goes to the capital markets to obtain financing. How to finance a firm was covered in the second major part of the book. Financing has a cost no different from materials or labor. Firms want to obtain their financing at the lowest cost but with an acceptable risk that fits the firm’s product market and financial strategies.

Chapter 5 used the firm Massey Ferguson to set the stage for our discussion of capital structure and firm financing. This chapter didn’t introduce tools or solutions as much as it raised important questions. It demonstrated that capital structure and how a firm finances itself matters. In particular, it demonstrated the importance of capital structure to a firm’s product market strategy and how inconsistent financial policies can negate a firm’s product market goals.

Chapter 6 provided the theoretical base for static capital structure theory, starting with M&M (1958). The chapter showed that in an M&M world capital structure did not matter. Later, M&M (1963) added taxes and the probability of financial distress, and then capital structure did matter. In a world with taxes, debt financing became more advantageous than equity financing.

Chapter 6 also discussed how the costs of financial distress are a key element in determining a firm’s optimal capital structure. What are the costs of financial distress? They include the direct costs of the bankruptcy process, though this is not the main cost. The primary cost is the possible permanent loss in a firm’s competitive position in its product market. The cost of financial distress is driven by the firm’s basic business risk.

Chapters 7 and 8 discussed how Gary Wilson, the CFO of Marriott Corporation, set capital structure policy. It explicitly showed why when a firm changes its product market strategy, it must also consider changing its financial policies. In particular, Marriott changed its product market strategy from owning hotels to managing them. When the firm financed and owned its hotels, Marriott had required an A bond rating for access to capital markets. However, after changing its product market strategy to only managing hotels, Marriott could increase its debt level (and live with the corresponding lower debt rating).

In Chapters 7 and 8, we introduced and reviewed many of the financial policy choices firms make: dividend policy, issuing debt domestically or internationally, secured or unsecured debt, short-term or long-term maturities, fixed or floating rates, and so on. We noted that corporate finance treats excess cash as negative debt. The chapters on Marriott also introduced the idea of asymmetric information and reiterated the concept of sustainable growth and the DuPont formula. In addition, these chapters discussed the cost of signaling and the importance of equity cash flows. We noted that equity cash flows out (dividends and stock repurchases) were seen by the market as a positive signal (with stock prices rising on average), while equity cash flows in (new equity issues) were viewed by the market as a negative signal (with stock prices falling on average).

Finally, we use Marriott to illustrate the five things a firm can do with excess cash flow: grow faster internally, acquire another firm or business unit, increase dividends, repurchase stock, and/or pay down debt. The first two of these are product market solutions, the latter three are financial market solutions. It is a complete reversal if the firm does not have enough cash flow. In that situation, the firm can grow more slowly, sell off assets, cut dividends, issue equity, or issue debt.

Chapters 9 and 10 looked further into how financial policies are set and how changes in a firm’s product market strategy affect a firm’s financial policies. To do this, we used the competitors AT&T and MCI. In particular, we looked at these two firms before and after a major change in their product market. These chapters examined the impact of AT&T’s divestiture of all of its operating subsidiaries. Both firms’ financing needs and financial policies were outlined before AT&T’s divestiture, with a discussion of whether each firm’s policies were consistent with each other and with the firm’s needs. Next, after the AT&T divestiture, the question of what the new funding needs were for these firms was examined. Finally, these chapters explored what AT&T and MCI’s financial policies should be post-divestiture.

For AT&T before its divestiture, access to the capital market was vital to raise funds for the firm’s huge annual capital expenditures. This meant AT&T had to maintain a very high bond rating, which in turn affected its optimal capital structure. At the same time, MCI required funding to build its infrastructure, but it did not have the cash flows or financial strength to obtain a high bond rating. Using this contrast, we discussed the pecking order theory. We noted that internal funds (from sustainable growth) is always the preferred funding alternative. Issuing risky debt and finally issuing equity follow as less-desirable alternatives.

Chapter 11 examined dividend policy and share repurchases at Apple Inc., asking how and when a firm should return cash to its owners. The presentation began with M&M (1961), which provides the theoretical basis of dividends. The chapter then relaxed the assumptions of an M&M world to explain how firms actually set dividend and share buyback policy.

Chapter 12 completed the section on capital structure theory and emphasized its dynamic element. In this chapter, we relaxed the last three M&M assumptions: that transaction costs are zero, that asymmetric information does not exist, and that there are no agency costs. Allowing positive but small transaction costs for issuing debt and equity is relatively minor and does not change the theory appreciably.

Allowing for asymmetric information makes a difference. It means that the market will react to a firm’s equity cash flows, including dividends, stock issuances, and stock repurchases. The pecking order theory also follows from information asymmetry. With agency costs, managers’ behavior is explained by their incentives, not necessarily the stockholders’ incentives. While some leverage can reduce agency problems, excessive leverage can exacerbate them.

The section on financial policies, Chapters 5–12, also provided us with an outline of how to make financing decisions. The steps are as follows.

1. Determine the firm’s financial needs
2. Set out the firm’s financial policies, including its capital structure target
3. List the firm’s options to obtain funding
4. Choose the financing (e.g., fixed vs. floating, secured vs. unsecured, etc.) that fits the firm’s financial policies at the lowest cost
5. Review the implications of the possible choices
6. Make the choice

Once a firm knows its financing needs (discussed in the first section of the book), the next step is to set out its target capital structure, which feeds into the firm’s debt rating. We said there are three criteria to use when choosing a target capital structure policy: internal, external, and cross-sectional.

The internal criteria are about evaluating and accounting for a firm’s basic business risk. Will the financial policies work in good times and bad? A firm’s competitive risk is assessed with pro formas and sensitivity analysis. The firm must consider whether the firm will be able to service the debt, meet the covenants, and so on. External criteria are those set out by the rating agencies, lenders, and analysts. To maintain access to the market, the firm must satisfy these external constituencies. And finally, cross-sectional criteria involve analyzing what the firm’s competitors are doing and only having different financial policies if there is a strong reason to.

Choosing a firm’s optimal capital structure is not just about minimizing the firm’s cost of capital (WACC). There are many financial implications to the firm. Capital structure affects the risk and return of the firm. It affects the cost of debt, the cost of equity, and the WACC. Remember, if the firm changes its debt-to-equity ratio, it changes its cost of capital. As the percentage of debt increases, the cost of debt goes up, the cost of equity goes up, and the WACC goes down and then up. The stock price goes up and then down as the value of the firm goes up and then down. EPS goes up, and P/E goes down. Tax shields go up, and the costs of financial distress go up.

Furthermore, setting an optimal or target debt/equity level is only half the job. Getting to the target is the other half. Set the debt/equity level too low, and the firm may become a takeover candidate because its stock price is too low and its own debt capacity can be used to finance its acquisition. Set the debt/equity level too high, and the firm runs the risk of financial distress. While a firm’s financial policies are set as a static equilibrium for the long run, the firm may need to dynamically deviate from them to take advantage of short-term situations.

When a firm sets its financial policies, it also conveys information to the market. The market knows that management has asymmetric information and looks for signals. This makes raising external funds more costly, and thus internal funds, generated through a firm’s sustainable growth rate, are more attractive.

After setting its financial policies, a firm next considers its options to obtain its funding needs. The firm can go to the capital market and choose from a number of choices and features. We did not cover them all in this book, but we did include bank financing, private placement, long-term debt, equity (common and preferred), convertible debt, convertible preferred, and so on. Each option includes a number of features such as the interest rate (level as well as whether it is fixed or floating), maturity, covenants, sinking funds, call provisions, and so on. There are a lot more possibilities than those covered in this book, but these are the main options used by firms.

From the choices available to fund the firm’s financing needs (given the firm’s financial policies), the firm should eliminate those that make no sense, are too risky, and so on. Finally, a firm should choose the cheapest financing that fits from the options remaining. Though not covered in this book, sometimes finding the lowest-cost option that fits means transforming other types of financing. For example, a firm could borrow in yen and undertake a currency swap to convert the loan from yen to U.S. dollars.

Finally, this section showed repeatedly why financial policies need to be consistent with each other and with the firm’s product market strategy. Notably, when a firm changes its product market strategy, it must also review and potentially change its financial policies.

Chapters 13–21: Valuation

On the investment side we asked: How does a firm make good investment decisions? We noted there are three elements to good investment decisions: a strategic piece, the valuation, and the execution. Most of the last part of the book was spent on the valuation piece. However, strategy and execution are also considered.

The strategic element was discussed briefly in many cases and in detail in our final case of Family Dollar. The strategic part of an investment is really the product market economics of the investment. Before we can value the cash flows from an investment, the underlying economics must generate them.

There are five major ways to value any investment (within each of these five ways there are many iterations, but your authors organize valuation around five “families”):

1. Discounted cash flows (e.g., free cash flows to the firm, free cash flows to equity, APV, EVA, etc.)
2. Earnings or cash flow multiples (e.g., P/E, EBIT, EBITDA, EBIAT, etc.)
3. Asset multiples (e.g., book value, market-to-book, replacement value, etc.)
4. Comparables (e.g., barrels of oil reserves, ounces of gold, acres of timber, square footage of retail space, population, number of visits to a website, etc.)
5. Contingent claims (i.e., an option valuation approach)

The book focused on the first four (contingent claims were not covered as they require an option value tool kit and are the least used in practice).

Our discussion on valuation began in Chapter 13 with a computational review of valuation tools, in particular discounting and net present value.

We then used Sungreen to demonstrate the basics of valuation in Chapters 14 and 15. In Chapter 14, we showed how to generate the free cash flows (FCF) to the firm using pro formas. The formula for FCF to the firm is as follows:

Chapter 15 used the projected cash flows estimated in Chapter 14 and discounted them at an appropriate cost of capital. For the free cash flows to the firm, this meant using WACC, which has the following formula:

To calculate the WACC, we estimated all of its various components. We also highlighted different techniques for some of the estimates: in particular the risk-free rate, the market risk premium, and how to lever and unlever the beta. Furthermore, we discussed some of the reasons for the different estimates used.

We emphasized that cost of capital is obtained from the marketplace and that a “twin” technique is often used. This is true for the optimal capital structure, the K_d, and the K_e. In corporate finance valuation today, K_e is obtained primarily from the CAPM (a one-factor model).

Chapter 15 also calculated a terminal value for Sungreen’s investment and emphasized that an investment valuation consists of three pieces: the initial investment cost, the present value of the projected cash flows, and the present value of the terminal value. Your authors strongly encourage computing multiple terminal values and keeping their values separate from the value of the cash flows. Why? In many projects, the determination of whether or not the project has a positive NPV depends critically on the terminal value. When all three elements are combined, it is easy to lose sight of this fact.

This chapter also emphasized that firms should use multiple hurdle rates when evaluating investments. We summarized our advice on this idea with the phrase “project’s cash flows, project’s capital structure, project’s cost of capital.”

Chapter 16 presented many nuances of the valuation of firms and projects. The chapter began with a series of cash flow nuances. After first emphasizing that “cash is king,” we discussed what should and should not be included in an investment’s cash flows. The excluded items include fictional accounting flows, sunk costs, charges for excess capacity, and so on. Items to be included are opportunity costs, cannibalization of cash flows elsewhere in the firm, and abandonment costs. This section emphasized that all incremental cash flows should be counted (wherever they occur in the firm), and their timing must also be captured.

A subsequent discussion about the nuances around the cost of capital included the warning not to confuse execution financing with the target capital structure. Also covered were the assumptions implicit in the WACC formula, how to treat subsidized interest rates, variations in the levering and unlevering formula for beta, and alternative methods to compute the cost of equity (e.g., the arbitrage pricing model and the Fama and French three-factor model).

The next section of nuances showed that the five principal methods to determine terminal values are the same five principal methods to value a project. Of note was the importance not to mix up the terminal value of equity and the terminal value of the firm (e.g., using a multiple of P/E provides the terminal value of equity, while using a multiple of EBIT provides the terminal value of the firm). In addition, we discussed the idea of using break-even terminal values as a reality check to back out the underlying valuation assumptions for each method. Finally, the chapter also looked at the nuances of alternative evaluation methods and included a review of adjusted present value (APV), real options, the politics of valuation, and the importance of corporate strategy.

Two final and important points about Chapters 13–16: A positive NPV indicates a noncompetitive return. There are only two ways a firm can undertake a project and obtain a positive NPV—either the firm obtains higher cash flows or it obtains a lower cost of capital than its competitors. Higher cash flows come from either higher prices or lower operating costs. A lower cost of capital usually means the firm is either obtaining a nonmarket rate (e.g., will obtain a subsidy) or is changing its tax shield and debt ratio (e.g., the firm that was acquired had the wrong capital structure and was not taking advantage of the tax shields). This idea is highlighted when the investment is a merger. When one firm takes over another firm or business, it usually pays a premium. The key question then is: Why is the business worth more to the acquirer than it is to the seller?

The second important point that follows from above: If a firm expects a positive NPV, it should be able to state where the competitive advantage is (and our rule of thumb is in five sentences or less). When someone is pitching a positive NPV project, several questions are required: Where is the positive NPV coming from? Where is the increase in cash flows coming from (e.g., where is the synergy)? Where is the reduction in cost of capital below market rates (e.g., where is the subsidy)? Without an adequate explanation, a positive-NPV project should not be believed.

Chapter 17 introduced LBOs and private equity by using Congoleum as a conceptual example. Where did the value come from in Congoleum? It came from three sources: the first two were related to the reduction in taxes, one from the write-up in assets (which tax laws restrict today) and the second from the extra interest deduction due to higher debt levels. The Congoleum case illustrated how strip financing was used to create a capital structure with a high level of debt for tax purposes. However, the cost of financial distress did not increase, since the debt holders’ interests were aligned with the equity holders’. This was a huge innovation that exists today with private equity firms. The third source of value in LBOs (and private equity) is the change in managerial incentives. LBOs reduce agency costs between owners and managers, and it has been shown that when managers work for themselves, they work harder and smarter.

Chapters 18–21 ended the valuation section with our final case, the acquisition of Family Dollar by Dollar Tree. These four chapters covered all three pieces of an investment (strategy, valuation, and execution). Chapter 18 explored the strategic reasons behind a potential merger. The economic issues raised in strategic analysis determine whether the pro formas and projected cash flows can be achieved.

Chapter 19 examined the valuation of the merger, using free cash flows to the firm discounted at the WACC. In particular, this chapter took the analysis that was done by Family Dollar’s advisors and reported in its proxy statement, and compared it to our own. The results showed why finance “is an art, not a science.”

Chapter 20 explained another popular technique for valuation, the free cash flows to equity. The free cash flows to equity are discounted at the K_e. The chapter also examined the differences between the free cash flows to the firm and the free cash flows to equity, taking the discussion from memorizing formulas to understanding them. Free cash flows to the firm are from the asset side. Free cash flows to equity and debt are to the liability side and discounted at K_d for debt and K_e for equity. Finally, this chapter showed that the free cash flows to equity is equal to the expected future dividends.

Chapter 21 dealt with execution. In the case of the Family Dollar merger, it explored the merger market and its many players, including the role of private investment firms. The motivations and details of the advisors (the investment bankers and lawyers), the board of directors, and management were all discussed with details from the proxy statements and a detailed example of the back and forth in merger deals.

The Family Dollar case also displayed the market’s role in valuation. The case included both the friendly and unfriendly aspects of mergers. Finally, we discussed that in corporate finance, in the long run, value matters. A firm may be able to make one mistake (or even a few mistakes), but at some point, if management makes too many mistakes, they will issue the last annual report with their pictures.

Tools and Concepts Discussed in This Book

At this point in the book, if your authors have been successful in teaching you corporate finance, readers should be familiar with all of the following:

Finance Tools

1. Ratio analysis
2. Sources and Uses
3. Pro formas
4. DuPont formula
5. Sustainable growth
6. Net present value (NPV)
7. WACC, K_d, K_e, K_o
8. FCF_f, FCF_e
9. Earnings multiples
10. Asset multiples
11. Adjusted present value
12. Multiple hurdle rates
13. Terminal values
14. Unlevering and relevering beta

Theory and Concepts

1. M&M (1958), (1961), (1963)
2. Tax shields
3. Costs of financial distress
4. Optimal capital structure
5. Cash is negative debt
6. Basic business risk
7. Managerial discretion
8. Asymmetric information
9. Signaling with equity cash flows/dividends/repurchases/equity issues
10. Internal capital markets
11. Pecking order
12. Dividend policy
13. Five ways to get or get rid of excess cash
14. Five major techniques to value a project

Institutional Factors

1. Investment bankers
2. Board of Directors
3. Lawyers
4. Covenants
5. Debt ratings
6. Convertibles
7. LBOs

The tools discussed in this book started with ratio analysis, Sources and Uses of funds, and pro formas and then quickly expanded. The tools were used multiple times in multiple situations to reinforce the learning process. The concepts discussed in this book started with M&M (1958, 1961, and 1963) and also quickly expanded to include issues such as asymmetric information, sustainable growth, and so on. The institutional factors, while not a focus of the book, were included in the discussions to illustrate how finance works in practice. Finally, many different financial instruments and their features were discussed, including covenants, ratings, and convertibles.

Finance as Art, Not Science

Finance, as we noted several times, is not precise. Finance professionals often act as though it is precise, but it is not. For example, when doing a valuation and computing an NPV, it should be clear that this is only an estimate. It is based on numerous assumptions, and sensitivity analysis needs to be done to examine how the assumptions affect the results.

Bottom Lines

The market is still a very good place to determine the value of an investment. What about our valuation techniques? The idea, as noted earlier, is not to get a precise number, but rather to get into the ballpark. Once in the ballpark, the decision of whether to invest and how to finance is made like all decisions are: with judgment. Unlike accounting (which looks backward), there is no one right answer in finance (which looks forward). While there are definitely wrong answers in finance, there is no single right answer. Finance requires judgment, and the importance (and scarcity) of judgment is why finance professionals are so well paid.

As noted in Chapter 19, one of your authors has a paper on valuation techniques and analysts.¹ Virtually every single analyst uses P/E. Just over half of all analysts also use NPV. The question: Which is more accurate, P/Es or NPV? They are about the same. Using NPV does not produce more accurate valuations than using P/Es. So why not simply use P/Es? Because using NPV forces the estimation of future cash flows and makes the analyst think through the underlying assumptions. In calculating free cash flows, the analyst must consider and review depreciation schedules, determine what the capital expenditures will be, what the firm must hold in working capital, and so on. By forcing the analyst to think through the assumptions, it reduces the chance she will miss something. With a P/E ratio, the analyst takes a single number and plugs it in, so it is easy to miss something. This is why your authors, and most finance professors, teach and prefer discounted cash flows (i.e., NPV). It forces one to think through all the pieces. We believe using discounted cash flows (DCF) makes a mistake in the valuation much less likely to happen, and today spreadsheets mean DCF does not take very much longer than using a P/E.

An Intelligent Approach to Finance

First, be sure to understand the economics. The value is in the economics of the product market and capital market. The value is not in the numbers. The numbers flow from the economics.

Second, understand the tools. This book has tried to focus not on the tools themselves but on understanding the tools. Applying a formula to unlever and relever a beta is straightforward. However, there are different formulas, and understanding the underlying assumptions and their impact (when they matter and when they don’t) is what this book is about. For example, the beta formula used in this book assumes the beta of debt is zero and the risk of additional debt is a linear risk. There are other formulas that have other assumptions. It is important to understand what a tool is doing and knowing when to use it. For instance, R_m – R_f will vary if it is determined using the arithmetic (correct) or geometric (incorrect) average. It will also depend on whether it is calculated from 1926 (from the start of when data exists), from the post–World War II period, or from just the last business cycle. Different methods and time periods each have their arguments, but what is key is knowing what the rationale is, where the number comes from, and why it is different from a number calculated with a different method or time period. This is why it is not correct to say one number is right for all purposes and another is wrong. Understanding the tools is critical to proper finance.

Third, people matter. Finance involves humans who operate in their own self-interest. Execution involves knowing the players and their self-interests and then making decisions. What does the CEO want? What do the investment banker and consultant want? What they say in words or numbers is not necessarily what they really think. They are going to act first in their own self-interest and second in the interest of the person paying them (and not what is in the interest of society or some other stakeholder). Doing the numbers is important, and it is nice to have the numbers, but humans make decisions in the real world. The importance of human behavior must be factored in.

Fourth, it is important to know the institutional rules. Chapter 17 and the Congoleum case showed that strip financing provided a huge advantage to LBOs. Why? Because they allowed the firm to get around an IRS rule and basically transform equity into debt for tax purposes. It is important to understand the economics—that’s where the real value is—but it is also important to understand the tools, the people, and the institutional framework.

Fifth, expect a zero NPV. When a NPV is positive, a key part of the analysis is determining where the value comes from. You should be able to explain where that value is in five sentences or less. If it can’t be explained in five sentences or less, it usually should not be believed.

Sixth, be at least a little (preferably more than a little) skeptical. Both your authors are fairly cynical and skeptical. As noted above, you should always question what people want, what are they getting, and where is the value to them, and you should be very skeptical of what people tell you.

Keeping Current

The world is constantly changing, with new corporate instruments and structures being developed all the time. LBOs and leveraged recaps were new in the 1980s. The dot-coms saw the rise of “burn rates.” Prior to the 1990s, short selling made up about 5–8% of all trades on the exchanges, while today short selling accounts for close to 30% of all trades. The only certainty is that the world is going to keep changing. How can you stay current?

Textbooks: Most updated editions of textbooks are written primarily to kill the used book market rather than because there has been a major advance in finance. So, while having the latest edition may not be critical, reading different textbooks (as opposed to different editions of the same book) provides a range of information. Brealy and Myers’ Principles of Corporate Finance is really the first modern textbook in corporate finance and remains an excellent source of information. Grinblatt and Titman’s Financial Markets and Corporate Strategy is your authors’ preference for advanced corporate finance and is a little more modern, a little more technical, and has more mathematical proofs. Finance professionals should have both of these textbooks on their bookshelf. Higgens’ Analysis for Financial Management is also a great textbook and delves into the details of basic corporate finance.

Journals: Many people subscribe to the MIT Sloan Management Review and the Harvard Business Review as coffee table magazines, and we agree this is where they belong for those interested in focusing on finance. There is very little finance in these journals. By contrast, many of the technical journals in the field (e.g., the Journal of Financial Economics, The Journal of Finance, The Review of Financial Studies, etc.) require a high level of math (i.e., calculus and econometrics) to understand. These are designed for academics and not for the general practitioner.² There are, however, practitioner journals that take the papers in these technical journals and boil them down. These journals include Financial Management, the Journal of Applied Corporate Finance, Financial Analysts Journal, and The Journal of Portfolio Management. These journals offer a way to access highly technical literature, but remember that they don’t have the same peer review as the more academic journals, which means they are more likely to contain mistakes. When reading the practitioner journals, it is important to keep this in mind. If you find something different from what you expected, it needs to be verified before you act on it.

The Business Press: Popular magazines, especially The Economist (followed perhaps by Bloomberg Businessweek) are very valuable to keep a pulse on what is happening in the general economy and finance. Your authors believe The Economist really should be essential reading for everybody. Euromoney is also a very good practitioner journal detailing current events in the field. And then of course there is your daily Wall Street Journal and/or Financial Times.

Larry’s Last (Really a True) Story

Jane, a friend’s sister, worked as the credit manager in her father’s firm (a medium-sized business) and had just experienced her first customer default. The customer went bankrupt and owed $30,000. The court settlement was expected to be only $3,000 (10 cents on the dollar). Jane was planning to inform her dad (who was not a warm and fuzzy individual) over dinner and had asked me for advice on how to present it.

I asked, “Is your Dad’s factory at full capacity? What is your profit margin?”

She replied: “No, it is not even at 50% capacity, and the profit margin is 30%. Why, what difference does it make?”

I explained that if the factory was operating at less than its capacity, this meant she had not forgone another profitable opportunity by selling to this customer. It meant she had not lost $27,000 (the $30,000 sale price less the $3,000 expected payment). Rather, she had lost $18,000 (the $21,000 cost of the product less the $3,000 expected payment).

I then asked, “Was this the first sale to this customer?”

An unpleasant facial expression was followed by, “And what difference does that make?”

Well, it turned out that the customer had purchased $330,000 worth of product over two years, of which $300,000 had been fully paid and another $3,000 payment was expected. This meant cash payments from this customer would total $303,000 when that last expected amount came in. The cost of product sold was $231,000 ($330,000 times the firm’s 70% cost of sales). Thus, the profit on the client (as opposed to the loss on the last sale) over the entire two years was $72,000 (cash in $303,000, cash out $231,000). The decision to extend credit to this customer was a good one. She invited me to dinner with Dad. I declined, but I may send her a copy of the book.

Paul’s Theory of Pies

If you ask, “What is your favorite pie?” most people in the United States would answer by saying it was apple. It is remarkable that a vast majority of people in the United States would prefer one particular pie. I have a theory for why this is true. Most people choose apple pie because it is probably the only pie they ever had that was made with fresh fruit. Cherry pie, peach pie, pumpkin pie, and others are all normally made with canned fruit. But there is no substitute for a fresh fruit pie. Apple is not the best pie. Have you ever had a peach or strawberry-plum pie (or any of a host of others) made from fresh fruit? If you have, then apple may not be your favorite. Once pie season begins, there is fresh pie in my office often (and usually not apple). I call it pie day. Consider that no one ever says I want to get a homemade pizza. For pizza, we say we want a pizzeria pizza. Why? It is because pizzeria pizza is better. There is also a reason people talk about a homemade pie. Because a homemade pie is the right way to make a pie, cook it with fresh fruit. You want it done right, the way it was done originally, and there really is a difference. Eat more pie.

Rules to Live By

Finally, your authors offer you some nonfinancial advice. Whenever we teach a class, after the last day’s review we tend to give some thoughts on life. Listed below are a few of the ones we feel are the most important:

First, do the things you enjoy. You will only be good at something you like to do. Don’t do something because you think you should do it. Don’t go take a job at Goldman Sachs because it is Goldman Sachs. Pick the job you want to do. Life is not about maximizing dollars. It is about maximizing utility. You need a certain amount of money, and hopefully any job you choose will provide the basics. Both your authors have had opportunities to make much more money in industry than as academics. So why have we stayed in academics? It is who we are and what we do. Neither of us made our career decisions based on money, and neither of us regrets our choices (we both would argue that being an academic—being paid to learn and teach in a wonderful setting—is perhaps the greatest job ever). If you are really good at what you do (which only happens if you choose a career doing something you like to do), you’ll make enough money at it. Walt Disney once said, “I don’t make movies to make money, I make money to make movies.”

Second, if you can’t explain something simply, realize it means you don’t understand it well. If you understand something well you can usually explain it simply. It is a rule we use for teaching (and hopefully this book demonstrates it). And this is true not just for you but for others as well. When people say, “I’d explain it to you, but it is too complicated,” in the vast majority of cases it means they don’t understand it well enough. Einstein once said, “You don’t understand something until you can explain it to your grandmother.”

Third, when writing a speech or making a presentation, do it as if you are speaking to your significant other. Forget preparing for a specific audience. Your significant other is reasonable and intelligent but won’t necessarily know the jargon of your profession (and most professionals can’t explain things without resorting to the jargon of their profession). Write your speech for your significant other, and you’ll never lose your audience. Showing your work to them is a great way to measure whether it is understandable or not.

Fourth, act ethically. It is easy to rationalize one’s actions, especially if they are approved by attorneys, accountants, or corporate boards. Unfortunately, advisors often play the role of enablers, helping managers figure out how to use rules and regulations to justify what are clearly wrongful actions. The fact that others are doing it, or that it is technically allowed, does not make it right. It is critical to maintain a certain sense of humility and to understand human nature, competitive pressures, and how a lack of clear guidelines can lead to potentially wrong choices. Each individual remains his or her only gatekeeper.³

Fifth, life can be hard. Unfortunately, at some point, almost everyone will suffer. People suffer because of injuries, disease, natural disasters, family tragedies, financial hardship, or simply old age. Out of the blue, someone has an injury, a freak accident, or is hit by disease. No one will get through life without suffering. However, what amazes us is that since we all know that we are going to suffer and that we are all going to suffer because of what the world does to us, why on top of that we also cause suffering to each other. Try not to.