Finance
by Stephen Ross, Randolph Westerfield and Jeffrey Jaffe
How should a company spend money?
Every company has to decide which long-term projects to invest in, how to pay for them, and how to manage its day-to-day cash. Ross, Westerfield and Jaffe's textbook answers all three with one goal in mind, making the company worth more to its shareholders.
Hear a sample · read by Laura
Money today is worth more than the same money next year, because today's can be invested. NPV turns every future cash flow into what it's worth today, adds them up and subtracts the cost. The authors' rule is to take projects with a positive NPV and turn down the rest.
The payback rule ignores everything after its cut-off date. The internal rate of return can mislead when projects differ in size, or when cash flows switch between positive and negative more than once. The authors test each rule against NPV, and NPV keeps coming out ahead.
When valuing a project, count only the cash that changes because you take it on. Ignore sunk costs, which are gone whatever you decide. Include opportunity costs, like the rent on a building you'd otherwise let out, and side effects on your other products.
Investors who own shares in many companies cancel out most of each one's own risks, so they aren't paid for bearing them. What's left is market risk, measured by beta. The Capital Asset Pricing Model turns beta into the return investors expect, and a project has to beat that return.
The economists Modigliani and Miller showed that, with no taxes, splitting a company between lenders and shareholders doesn't change the size of the pie. Add corporate taxes and debt helps, because interest cuts the tax bill. Add the costs of financial distress and too much debt hurts.
The goal
A company's managers should aim to make the owners' shares worth as much as possible.
Agency problem
Managers don't always act for the owners. Pay, perks and job safety can pull them another way.
Cash flow
Judge projects by the cash they bring in, since accounting profit can hide when the money actually arrives.
Beta
A stock's beta measures how much it moves with the market. Higher beta means investors expect a higher return.
Debt and tax
Borrowing saves tax, because interest is paid before tax is worked out. Too much debt raises the risk of going bust.
One thing to try
Take a purchase you're weighing, like a new boiler or a course. Note what it costs now and what it saves or earns each year. Using the interest your savings could earn instead, work out what each year's saving is worth today, and see whether the total beats the cost.
Knotd has the key ideas from 250+ non-fiction books, each in a few minutes, in plain words. Corporate Finance comes with a Name That Idea round and a Spot the Trap case to make it stick.
Get the whole book on KnotdOpen in the appHow should a company spend money? Every company has to decide which long-term projects to invest in, how to pay for them, and how to manage its day-to-day cash. Ross, Westerfield and Jaffe's textbook answers all three with one goal in mind, making the company worth more to its shareholders.
Net present value; Why other rules fall short; Only incremental cash counts; Paid only for market risk; Slicing the pie.
Take a purchase you're weighing, like a new boiler or a course. Note what it costs now and what it saves or earns each year. Using the interest your savings could earn instead, work out what each year's saving is worth today, and see whether the total beats the cost.
Yes. Knotd has the key ideas from Corporate Finance in a few minutes, in plain words, plus a Name That Idea round and a Spot the Trap case to test them. It's one of 250+ non-fiction books in the app.
