Finance
by Richard Brealey, Stewart Myers and Franklin Allen
Which projects are worth doing?
Every company keeps deciding what to spend money on and how to pay for it. Brealey, Myers and Allen use one test for both. Does it add more value for the shareholders than it costs them? Most of their long textbook is about applying that test without fooling yourself.
Hear a sample · read by Laura
Discount each year's expected cash flow back to today, add them up and take away the cost. The discount rate is what shareholders could earn elsewhere on something equally risky, the opportunity cost of capital. If the answer is above zero, the project makes them richer.
A spreadsheet can make anything look profitable. The authors ask what edge, such as a patent or lower costs, lets you earn more than the cost of capital before rivals copy you. They call those extra profits economic rents. Without an edge, a big NPV is usually a forecasting mistake.
In an efficient market, prices already reflect what is known, so yesterday's move says nothing about tomorrow's. The authors turn this into lessons for managers. Waiting for the share price to 'recover' before issuing shares is guesswork, and the market price usually deserves more trust than your hunch.
The authors call it the law of conservation of value. A firm is worth what its assets will earn. Repackaging them, by merging two businesses or swapping shares for debt, creates nothing when investors can diversify and borrow on their own. Taxes and costs are where the real arguments start.
Time
Money today is worth more than the same money next year, because it can be invested meanwhile.
Net present value
Take on a project only if the cash it brings in, valued as money now, is more than it costs.
Opportunity cost
Judge a project against what investors could earn elsewhere by taking the same risk.
Diversify
Spreading money across many investments cancels out most of the risks tied to one company.
Market risk
Investors are paid only for the risk they can't diversify away, the ups and downs of the whole market.
A story from the book
In 1953 the statistician Maurice Kendall went looking for regular cycles in share and commodity prices. He found none. Week to week, prices wandered as if chance picked each move. The authors open their case for efficient markets with his surprise.
One thing to try
Pick one spending decision coming up, at work or at home. Write one sentence on why it should earn more than the money could elsewhere at the same risk. If you can't name the edge, the authors would tell you to trust your forecast less.
Knotd has the key ideas from 250+ non-fiction books, each in a few minutes, in plain words. Principles of 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 appWhich projects are worth doing? Every company keeps deciding what to spend money on and how to pay for it. Brealey, Myers and Allen use one test for both. Does it add more value for the shareholders than it costs them? Most of their long textbook is about applying that test without fooling yourself.
Net present value; Where positive NPVs come from; Markets have no memory; Value adds up.
Pick one spending decision coming up, at work or at home. Write one sentence on why it should earn more than the money could elsewhere at the same risk. If you can't name the edge, the authors would tell you to trust your forecast less.
Yes. Knotd has the key ideas from Principles of 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.
