Restructuring and Managing the Enterprise in Transition
Roy L. Crum Itzhak Goldberg
Copyright © 1998
The International Bank for Reconstruction and Development / THE WORLD BANK 1818 H Street, N.W.
Washington, D.C. 20433, U.S.A.
All rights reserved
Manufactured in the United States of America First printing July 1998
The Economic Development Institute (EDI) was established by the World Bank in 1955 to train officials
concerned with development planning, policymaking, investment analysis, and project implementation in member developing countries. At present the substance of the EDI's work emphasizes macroeconomic and sectoral
economic policy analysis. Through a variety of courses, seminars, and workshops, most of which are given overseas in cooperation with local institutions, the EDI seeks to sharpen analytical skills used in policy analysis and to broaden understanding of the experience of individual countries with economic development. Although the EDI's publications are designed to support its training activities, many are of interest to a much broader audience.
EDI materials, including any findings, interpretations, and conclusions, are entirely those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent.
Because of the informality of this series and to make the publication available with the least possible delay, the manuscript has not been edited as fully as would be the case with a more formal document, and the World Bank accepts no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available.
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Roy L. Crum is professor of finance and director of the University of Florida's Center for International Economics and Business Studies.
Restructuring and Managing the Enterprise in Transition 1
Itzhak Goldberg is a program team leader in the Private and Financial Sector Development unit of the World Bank's Europe and Central Asia Region.
Library of Congress Cataloging−in−Publication Data
Crum, Roy L.
Restructuring and managing the enterprise in transition / Roy L.
Crum, Itzhak Goldberg.
p. cm.—(EDI learning resources series, ISSN 1020−3842) ISBN 0−8213−3658−4
1. Corporations—Europe, Eastern—Finance. 2. Corporations—
Former Soviet republics—Finance. 3. Privatization—Europe.
Eastern. 4. Privatization—Former Soviet republics. I. Goldberg, Itzhak, 1947− . II. Title. III. Series.
HG4133.7.C78 1998 96−22711 658.4'06—dc20 CIP
Contents
Foreword link
Preface link
Introduction and Overview link
Appendix A. Private Enterprise and the Market Economy link Appendix B. The Role of Capital Markets in a Market Economy link Chapter 1. The Time Value of Money, Risk, and Rates of Return link Appendix A. Present Values, Future Values, and Annuities link Appendix B. Setting the Risk Premium for a Risky Loan link Chapter 2. Financial Accounting: The Language of Business link Chapter 3. Discovering Meaning in Accounting Information link Appendix
Financial Ratios
link
Chapter 4. Pricing, Costing, and Managing the Contribution Margin
link
Chapter 5. Managing Assets and Inventories link Appendix
The EOQ Model: An Example
link
Chapter 6. Managing Liquid Assets Effectively link Appendix
Building the Cash Budget
link
Chapter 7. Financing Decisions and the Impact of Debt on Company Value
link
Contents 2
Appendix
Rates of Return with Multiple Currencies
link
Chapter 8. Models of Investment Analysis link
Appendix A. Inflation, Forecasting, and the Calculation of Present Values
link
Appendix B. Cost of Capital and Project Hurdle Rates link
Appendix C. Building Yearly Cash Flows link
Chapter 9. Project Analysis and Selection link
Appendix
Competitive Bids and the Decision to Make or Purchase
link
Chapter 10. Valuation of Enterprises link
Appendix
Determining the Base Scenario for Company Valuation
link
Chapter 11. Corporate Governance and the Role of the Chief Financial Officer
link
Chapter 12. Competitiveness and the Business Environment link Appendix
Indicators for Potential and Resilience
link
Chapter 13. Restructuring to Enhance Value link Chapter 14. Restructuring to Create Competitive Advantage link
Chapter 15. The Tools of Restructuring link
Chapter 16. Restructuring of an Enterprise in Transition link Appendix
Writing an Effective Business Plan
link
Foreword
EDI's training activities in Eastern Europe began in the early days of the transition to a market economy in 1989 and grew rapidly after the dissolution of the former Soviet Union in 1991. The topic of privatization and
restructuring of enterprises featured prominently in EDI's program of activities at that time. This book is based on materials prepared for a management training program for Polish, Czech, and Slovak managers delivered between 1990 and 1992 and a training−of−trainers program in project analysis for the countries of the FSU delivered between 1992 and 1993. The book also reflects the authors' experiences in training and advisory work with the World Bank's private sector arm, the International Finance Corporation, in Nizhny Novgorod, Russia between 1993 and 1995.
As part of EDI's contribution to the important process of enterprise restructuring in Europe and Asia, the book discusses ways of adapting and applying traditional methods of financial management to the needs of the former socialist transition economies. Restructuring and Managing the Enterprise in Transition will be of interest to managers of privatized enterprises, officials of regulatory bodies developing market−friendly policy
environments, as well as academics in Central and Eastern Europe and the former Soviet Union. It can be used as a textbook in Master's−level courses in business administration as well as in mid−career executive training
Foreword 3
programs. The book has also been translated into Russian at Tashkent State University in Uzbekistan.
VINOD THOMAS DIRECTOR
ECONOMIC DEVELOPMENT INSTITUTE
Preface
This book has a twofold objective. First, it adjusts traditional financial management tools to the needs of ex−socialist enterprises undergoing restructuring. Second, it presents a management approach to restructuring based on the strategic concepts of Porter combined with the restructuring experience accumulated in Central Europe and the former Soviet Union by individuals and institutions, including local and foreign consultants working with the World Bank.
This dual focus is intended to make the book useful for persons engaged in restructuring and managing
enterprises. The book reviews standard financial concepts and tools, adjusts them when necessary to the unique conditions in the ex−socialist enterprises, and then presents the restructuring context and some strategies that are based on the application of these tools.
The legacy of central planning affects not only the financial accounting systems of the enterprise but also the decision−making and business strategy formulation processes. This includes an overly centralized management style with no delegation of authority. Many of the unique features of ex−socialist enterprises are caused by the simultaneous interaction of this legacy and macroeconomic instability (particularly, high, variable, and
unpredictable inflation). These problems are on top of a high uncertainty in trade regulation and real changes in prices and interest rates.
The book is an outgrowth of a training program we initiated for the Economic Development Institute (EDI), the training arm of the World Bank. The initial program was designed in 1990 for a Central European (CE) audience.
Another program was launched in 1992 for participants from the former Soviet Union (FSU).
It was our intention from the start to develop training materials that could help to bridge the gap between Western theory and the reality of ex−socialist countries. For this reason, the training programs were developed with local academic and research institutions from the countries in the region. This cooperation allowed us to develop a familiarity with financial evaluation processes and the analytical methodologies used in a central−planning environment. It also familiarized us with local accounting practices in theory (the academic perspective) and in practice.
We also worked closely with company management in enterprises in the former Soviet Union and in Central Europe. These activities were a part of the International Finance Corporation's investment and advisory work in Nizhny Novgorod, Russia, and privatization and restructuring work in Poznan, Poland.
What is the justification for writing a new book for managers of the enterprise in transition when so many Western books are available? A new text is needed because of the wide gap between Western concepts and their application in the ex−socialist countries
during the transition. This gap is too wide to ignore. Most Western models in financial management make assumptions about the efficiency and stability of markets and the signals that can be obtained from them. They also assume that traditional accounting information is available and can be used for management purposes.
Preface 4
These assumptions are not valid in most of the ex−socialist countries, so an adjusted paradigm is needed to manage the finance function in a transition economy experiencing hyperinflation. We believe that the adaptations of financial techniques described in this book will enable mid−career directors or senior managers in an FSU or CE company to apply these concepts to their companies during the transition.
Book Organization
Chapters 1 through 11 introduce the basic concepts of financial management: return and risk, time value of money, financial accounting (including the impact of inflation on accounting), pricing and costing, asset utilization, cash flow management, capital structure, and, finally, investment analysis and enterprise evaluation.
These concepts are presented through the story of a fictitious company from one of the ex−socialist countries in the process of restructuring—the Eastern Europe Electronics Company. Issues of special relevance in the period of economic transition are emphasized in Chapters 1 to 7: the effect of risk and inflation on the time value of money, the restatement of financial reports and updating of data to the current period, and similar things. The issue of cost becomes very important for restructuring: sunk cost for existing assets, marginal cost for new operations and the treatment of shared overhead, opportunity cost of assets and their negotiated value for joint ventures, and so on. Inventory and receivables management deserve special treatment because of the
inter−enterprise arrearages and the high level of old inventories in some companies.
Project and company evaluation (Chapters 8 to 10) are topics of major interest because of the combination of privatization and restructuring. Structuring cash flows is a challenging exercise in any environment. Given the uncertainty in Central Europe and especially in the former Soviet Union, the challenge is even greater. We discuss the problems of forecasting cash flows in constant prices under different assumptions about inflation: neutral and non−neutral, predictable and unpredictable, and we suggest when such forecasts can be used for planning
purposes.
Corporate governance and shareholder control (Chapter 11) are crucial topics for successful restructuring.
Changes in the management culture and the restructuring of existing state−owned enterprises require pressure by shareholders on management. However, in most of the privatization schemes, especially the one adopted in Russia, the control of shareholders over management is limited, and employee−shareholders usually follow the wishes of top management. Outside control in Russian enterprises is almost nonexistent, and it is far from effective in many other countries. Chapter 11 introduces a new important role in the market−oriented enterprise:
the chief financial officer (CFO), whose functions are very different from the traditional economic director.
The second part of the book (chapters 12−16) starts with the industrial organization economics model popularized by Michael Porter and describes the sources of enterprise competitive advantage and the effect of management on acquiring this advantage (Chapter 12). Then the tools presented in chapters 1−11 and the Porter−type model are used to analyze restructuring. The book goes beyond Porter's framework by using a capital mar−
ket model to analyze an enterprise's strategic objectives and its unique needs for restructuring.
A conceptual framework (Chapter 13) defines the objective of restructuring as an attempt to increase the competitiveness of an enterprise and thereby enhance its value. Restructuring of a large, diversified privatized enterprise as a whole is more difficult than restructuring part by part: Most investors or other outsiders who examine privatized companies, especially in the FSU, conclude that only part of the enterprise—a product, a department—can be made viable. Core competitiveness, vertical integration, economies of scale, and economies of scope are the main concepts used to analyze the problems of companies before restructuring.
Chapter 14, "Restructuring Issues and Problems," addresses dimensions of competitiveness. These include scale, scope, quality, process technology, workflow, marketing mix, distribution, promotion, capital structure, cash flow
Book Organization 5
management, reserve capacity, performance evaluation and incentives, and governance control.
Chapter 15 focuses first on vertically integrated companies and "spin−offs." Then we present a list of
restructuring tools: make or buy, marginal costing and sunk cost, pricing, contribution margin analysis and joint production, and, finally, the role of cost accounting in decisionmaking.
In Chapter 16 we conclude the study of the 3E Company with a discussion of its restructuring problems and proposed solutions. Many of the concepts discussed in the second part of the book are used in this chapter to develop the plans by which 3E can be transformed into a profitable competitor for the long run.
Target Audience
This book contains valuable information for practioners, politicians, and academicians. Practitioners include managers, directors, and supervisory council members in ex−socialist enterprises. Practitioners may be engineers and science graduates or accountants and economists. Both groups should benefit from the strategy and
techniques (accounting, financial) that this book offers. The book does not target small−business owners or managers because its focus is on the large enterprise. However, the same basic techniques can be applied to small companies, even start−ups.
The broad audience for this book extends to officials of privatization and property agencies, industry ministries, and regulatory bodies (antimonopoly, tariff, and rate control in utilities, transport, and social services). These individuals should be familiar with the inner workings of the enterprise sector. Such familiarity is essential for market−friendly regulation and policymaking in all areas of industry, taxation, licensing, barriers to entry, bankruptcy, export promotion, and, if applicable, industrial policy.
Although designed primarily for practitioners, the book covers the theoretical foundations of economics, finance, and management. Academicians in economics, accounting, management, and finance should find it particularly useful in designing courses for persons seeking a Masters in business administration and for executive mid−career education. Ample material is provided for course design at different levels.
Finally, the target audience is not limited to readers in Central Europe and the former Soviet Union. Consultants and other Westerners may find this book, especially Part II, a useful introduction to management and restructuring issues in ex−socialist enterprises.
How to Use the Book
The book is best used in its entirety, either for an MBA program or for a mid−career executive training course.
However, the following chapters can be taught separately as modules: basic course in investment analysis
(Chapters 1, 2, 3, 4, 8, 9, 10); basic course in short−term asset management (Chapters 1, 2, 3, 4, 5, 6); basic course in business strategy (Chapters 1, 2, 3,4, 10, 12−16); and basic course in enterprise reform policy (Chapters
11−16).
The gap between the academic disciplines of economics, accounting, and management, as they have developed in the West, and actual business practices in enterprises in the ex−socialist countries is striking. By adapting the theoretical concepts developed for the efficient markets of the West so that they can be used meaningfully by practitioners/ managers, we have attempted to narrow the gap.
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Target Audience 6
We would like to express our special thanks to Ira Lieberman for his encouragement and suggestions during the preparation of this volume. We dedicate the book to Joyce and Odette.
Introduction and Overview
This book is intended to introduce managers and teachers to some of the fundamental concepts of corporation financial management and closely related business disciplines. The primary focus of the book is the business enterprise and how to help managers make sound economic decisions within companies that create value for shareholders, employees, customers, suppliers, and society in general.
Much of the information presented in the book involves ideas that are taken for granted in the Western industrialized countries but that are largely foreign in the ex−socialist world. Many Western textbooks on managerial finance discuss these ideas, but what is not treated in them is the connection between the conceptual models used in the highly developed markets of the West and the way to adapt them to Eastern and Central European economies in transition. When uncertainty is great—as it invariably is during periods of economic, political, and social transformation—context is needed to place free−market economic models into proper perspective. This is why this book introduces the models in the context of a company trying to operate and to survive during the transition period.
Market and Command Economies: A Comparison
An economy operating on the principle of free markets depends largely on the independent judgment of individual consumers, as revealed by their purchasing decisions, to drive the resource allocation process. This notion of ''consumer sovereignty" is a hallmark of Western market economies. In these countries, no central mechanism imposes detailed allocation policies, so there is relatively little bureaucratic interference with market forces. Only broad rules, designed to ensure fair treatment of all market participants, govern the process.
In a market economy, decisions to acquire input resources, to use a particular process technology, and to
determine what and how much output to produce are almost entirely in the domain of the individual business firm.
To survive, businesses must be responsive to the wishes of their customers. Because governments have minimal involvement in the process, it is the responsibility of the firm and its managers to identify and react to any changes in the environment that call for a revision of operating plans. If the firm's managers make timely, correct business decisions and produce goods and services in demand by society, the company thrives and they are rewarded. If they misread the signals and allocate resources to produce goods and services that are not in demand, the company goes bankrupt and they are out of a job. Hence, the success of a company directly depends on how effective it is in responding to the changing needs of the marketplace. Potential rewards from success are high, but a company must take risks and be innovative to succeed.
Because of the great difference in the role and responsibility of company management in a market economy and a command economy, business operations are organized and run in very different ways in the two systems. The objectives of management, the data
needed to run the business, and the behavior expected of managers differ. In a period of transition from a command to a market economy, familiar operating procedures and perspectives that were appropriate under the old regime no longer work and have no relevance as market forces start to develop. Change is everywhere. New kinds of information are suddenly needed before decisions can be made. The ways data are analyzed and
alternatives are evaluated are very different from the old system. In fact, even the kinds of decisions that must be made by management are profoundly different.
Introduction and Overview 7
Western competitors understand how to operate in a free market environment. Most are very efficient and
effective in doing so. If markets in once centrally planned countries are opened to competition from these Western companies, local industries must adapt quickly to the new way of thinking and learn to be competitive. Otherwise they will die. Closing the markets to foreign competition would be equally disastrous because progress toward international competitiveness would be seriously impeded or even blocked by such a policy.
It is imperative that managers, government officials, labor union leaders, and others involved in making enterprise policy decisions be exposed to Western business ideas and learn to cope with the challenges of a free market economy. Many subjects in the field of business are taught in the ex−socialist countries. Human resources
management, accounting, economics, computer sciences, and, to some extent, marketing have all been introduced from a free market perspective in these nations. However, much less is understood about the effective allocation of scarce resources to productive processes and the financing of the private business enterprise through capital markets. This field is known as "corporation financial management" or, as it is sometimes called, "corporate finance" or "managerial finance." It is of vital importance to companies in transition to a market economy.
Eastern Europe Electronics Company
The company used in this book as a vehicle for describing the application of corporate finance ideas in the real world is a composite of several actual firms. Eastern Europe Electronics Company (3E Company) is a large producer of both industrial and consumer products. In the past it was a primary supplier of military electronic equipment such as radars, field telephones, and two−way radio equipment for the Warsaw Pact. It also enjoyed a large market domestically and within Comecon for industrial products such as electronic testing equipment, thermostats, pressure control valves, engine speed controllers, and electric motor governors.
In the late 1970s production was expanded to include consumer electronics goods such as radios, phonographs, and cassette tape players. Although mainly sold domestically, about 30 percent of sales of these products were to other Comecon countries. Almost no sales were made to the West, the only exception being engine speed controllers and electric motor governors. Several contracts had been signed with German firms to provide these parts, but the sales had never been more than 5 percent of exports.
In January 1993 the company was reorganized as a joint stock company owned by the Treasury. It was also identified as a prime candidate for privatization "in the near future." The government appointed a governing Supervisory Council to oversee the operations of the 3E Company. This Council, in turn, appointed a
Management Board consisting of the previous managing director, chief engineer, and chief accountant, plus two additional
members. Both of these new members were nominated by the company's Workers' Council.
The Management Board is responsible for running the day−to−day affairs of the company. To make the company a viable candidate for privatization, the board suggests changes that need to be made in the structure of the firm and the way in which it operates. The Supervisory Council monitors the activities of the Management Board, ratifies its decisions, and suggests other changes to increase the efficiency and profitability of 3E's operations.
Product Lines
After the collapse of the Comecon trading bloc and the dissolution of the Warsaw Pact, the demand for various 3E products changed significantly. Even before the company was reorganized as a joint stock company, the Ministry of Industry had decided to scale down the production of military hardware and to refocus attention on Western markets. The firm retained three major product lines that it hopes to expand: consumer electronics, electronic test equipment, and industrial control systems.
Eastern Europe Electronics Company 8
Consumer Electronics
Currently in production are radios, phonographs, cassette tape players, and integrated "stereo" systems with all three components packaged into a single chassis. When similar products from the Far East became available in the country, domestic sales virtually collapsed. Now export sales are about 90 percent of the total, and sales overall have fallen by almost 60 percent in the past two years. Most of the remaining sales go to the Asian republics of the Commonwealth of Independent States (CIS), North Korea, and Vietnam.
Electronic Test Equipment
The prospects for electronic testing equipment are brighter than for consumer electronics. The 3E Company manufactures a range of meters and signal generators used in the repair and testing of electronic components.
Current sales are about half of what they were two years ago and are mostly domestic. The 3E products still enjoy a significant local cost advantage over imports although their quality and features are not as good. Most
knowledgeable observers believe that the 3E products should be competitive at the low end of the international market. Meters and test equipment manufactured in what was East Germany were the major competition in the Comecon area, but the German products are no longer price competitive. The primary reasons why sales are down by 50 percent are the collapse of Comecon and a failure to develop new markets in the West.
Industrial Controls
Industrial control systems and equipment include thermostats, pressure control valves, engine speed controllers, and electric motor governors. Sales of these products are roughly 40 percent of what they were two years ago, and they are about evenly divided between export and domestic markets. The main export market is the former Comecon countries that need replacements when machines break down. (The technology is fairly old, and no direct substitutes are easily available from the West. The Western equivalents are much more technologically advanced and expensive.) In the coming years the company expects increasing competition in these markets from products made in the Far East.
Intermediate Goods
While the three product lines are the major sources of sales, the 3E Company also produces intermediate goods.
Virtually all integrated circuits (ICs) used in the consumer electronic products and the testing equipment are designed and manufactured by 3E. Plastic extrusions and moldings for the front panels of meters and consumer products also are produced locally. The metal stampings and component boxes required for equipment chassis are made in the 3E factories as well. Manufacturing capabilities for these components were acquired when the company produced military equipment. The same production lines—indeed, even the same individual components—could be used in the manufacture of many other products by 3E, so all production of these intermediate goods was handled within the company.
Extreme vertical integration is still the case, but the discontinuation of military hardware production has created substantial excess capacity. The company has never explored the idea of producing these intermediate goods for other firms either within the country or for export. Neither has it checked to see if the goods could be acquired from an external vendor more cheaply than it costs to produce them internally. In fact, it is doubtful that the company even knows the cost of internal production.
Company Condition
When production of military hardware was discontinued, the workforce of the 3E Company was reduced by roughly 25 percent. Some of this reduction came from retirements, but many employees were laid off. Rumors persist that this was only the first of several planned reductions in force, and the Workers' Council is becoming
Consumer Electronics 9
more militant. Salaries have not kept pace with inflation, so the workers are pushing for a substantial wage increase. Management so far has deflected this demand, but the pressure is building up.
Currently, there are four separate manufacturing plants owned by the 3E Company. Plant 1 is the location of the main company offices. Production lines for metal stampings, component boxes, and pressure control valves also are located in Plant 1. This facility formerly produced military hardware products, but these facilities are now unused. Approximately 60 percent of the layoffs of workers came from this plant.
Plant 2 was also used for military production. Radars and two−way radios were the major products manufactured in Plant 2, and some IC production and plastic extrusions supporting the military operations were located there as well. Consumer electronics are produced in Plant 2, but it is running at less than 40 percent of capacity. Most of the layoffs other than from Plant 1 came from this facility.
Plants 3 and 4 never had any military production, so they have escaped the workforce reductions so far. Electronic testing equipment, plastic extrusions, and some integrated circuits are produced at Plant 3. Thermostats, engine and motor controllers, and metal stampings and component boxes are produced at Plant 4. There is little extra space available for expansion at these two plants, but production is averaging about 50 percent of capacity.
Credit in the country is scarce and very expensive. All loans must be fully secured and, with few exceptions, must be repaid within one year. Intercompany credit is also increasing, with the average account overdue by more than 180 days. Management needs capital to modernize the production facilities and to acquire technology, but none appears to be obtainable.
Preparing for Privatization
The Supervisory Council of the 3E Company has been given a mandate by the government to prepare the enterprise for privatization. Wanting to take the company private as quickly as possible, the supervisory council has identified five issues that must be addressed before privatization can start.
First, the Company's Workers' Council has stated that a pay increase must be the highest priority for management.
Workers are threatening to strike if their demands are not met soon.
Second, the government wants the firm to find a Western partner quickly that would be willing to take a substantial part of the company when it is privatized. The government is willing to resist labor demands for the time being (unless the workers become too militant just before the upcoming election), but it is unwilling and probably unable to grant any financial relief. Foreign exchange needed to acquire new technology is not available from the government. The only viable sources of funds are a joint venture, export earnings, or equipment
financing from foreign manufacturers.
Third, suppliers are threatening to cut off the company unless the overdue accounts are paid soon. One supplier of paper and resin circuit boards now requires cash on delivery, and the company is having trouble finding the cash to make the payments.
Fourth, because of the increasing availability of competing products from the Far East, the company is afraid to put too much pressure on its customers for payment, fearing that pressure will cause customers to look for other suppliers that can be more flexible.
Fifth, foreign consultants analyzing the 3E Company for the World Bank have suggested the following actions to make the company an attractive and viable candidate for privatization:
Preparing for Privatization 10
• Close at least one factory and realign production at the other three plants. All similar production (such as plastic extrusion and molding or IC production) should be located at a single plant and should serve the needs of the entire company.
• Verify that it is cost effective to produce integrated circuits, plastic extrusions, metal stampings, and component boxes internally rather than buying them in the marketplace. If it is profitable to produce these components, the company should identify potential customers outside the firm and try to secure extra sales.
• Rationalize production lines and establish work flow patterns to maximize operating efficiency. Production bottlenecks and quality control lapses can be identified and corrected more easily if this is done.
• Court domestic and export markets aggressively, particularly in the East, for the next two years. Identify technology requirements for serving Western market niches effectively and develop least−cost strategies to acquire the technology.
• At a minimum, realign the workforce to increase productivity. Further reductions in personnel may need to be made. Overhead costs for administrative personnel is a good place to look for savings. Cost centers and profit centers should be established as quickly as possible to gain control over overhead expenses.
• Ensure that net cash flow is positive and that all obligations can be met on time. Develop and implement a plan to reduce past due accounts over a short period. This should be one of the major objectives of management in the short run.
This capsule description of the Eastern Europe Electronics Company presents the problems facing the
management as it tries to move toward privatization. Additional details about the 3E Company will be provided in the chapters that follow.
Organization of the Book
The chapters of the book are arranged to allow the reader to focus on two related but separate topics. Chapters 1 to 10 are an introduction to corporation financial management within the context of a transition to a free market economy. They develop specific decision models and describe how the models can be applied. In order to provide a linkage with the real world, these discussions are closely tied to the 3E Company and the issues it faces. Chapter 11 to 16 then use the conceptual information developed in the first ten chapters to address major issues in
planning the transformation of companies from state−ownership to private ownership. The 3E Company again serves as the context around which the discussion is developed.
The information presented in chapters 1 to 10 is valuable and worth studying even if the reader does not complete chapters 11 to 16. It attempts to prepare the manager for making good economic decisions in day−to−day business situations. This material will enable the manager to understand how potential partners in a Western joint venture think and analyze investment proposals. It will identify the kinds of information that management needs in order to make decisions attuned to the marketplace, and it emphasizes the role of the market as the driver of the planning process.
Chapters 11 to 16 address the specific issues in restructuring and privatization that are difficult to resolve and perhaps a bit controversial because of their impact. We develop an analytical framework for addressing the issues and suggest, within the context of the 3E Company, how they might be viewed. These chapters make clear that management is a complex process, one characterized by the need to make decisions in the face of uncertainty and to maintain the flexibility to change quickly when new information is available.
Organization of the Book 11
Appendix A to the Introduction:
Private Enterprise and the Market Economy
A marketplace is often portrayed in economics textbooks as a smoothly operating monolithic exchange
mechanism in which the "invisible hand" guides all participants who wish to buy or sell their wares. In fact, the competitive marketplace that has developed in the Western industrial countries is vastly more complex.
Companies are both customers and suppliers of goods and services. Individuals are both consumers of enterprise outputs and suppliers of labor services and capital. Additionally, there is a very well−defined separation of tasks within the competitive marketplace according to the dictates of comparative advantage. Specialization of labor and production is a reality.
The Corporation as the Nexus of Market Interactions
The marketplace is actually a series of specialized markets for various kinds of resources. In one sense these specialized markets are separate entities. Yet, at the same time, they are highly integrated. Three types of markets are tied together by the corporation and are the primary components of the marketplace: the capital markets, the product markets, and the labor markets. We can use them to demonstrate the high degree of interrelatedness.
Each of these markets is shown in Figure A−1. Consumers demand goods and services at particular prices.
Corporations choose to supply them if the prices are high enough. This is the product market, and the price at which the consumer is willing to buy the product and the company is willing to sell it is the equilibrium price. The market mechanism itself determines the equilibrium price for most goods and services in a market economy without interference by outside forces such as the government. We note that the corporation also participates in the demand side of the product market when it purchases raw materials and semifinished inputs for its production process from other companies.
Notice that consumers and the corporation also interact in the labor market. Consumers offer their labor to the company at a price that will induce them to work. The corporation, in turn, agrees to hire them and to pay them a specific wage. If this wage is sufficient to induce the consumers to work, it is an equilibrium wage rate. We need to make a distinction between regular consumers/workers on the one hand and managers (who are also
consumers) on the other hand. The distinction is necessary because the two groups differ fundamentally.
Managers are also agents for the shareholder−owners and, as such, they have a fiduciary relationship with the company. In other words, they are obligated to act in the best interests of the owners as they carry out their duties.
Regular workers are not bound to the enterprise as tightly and do not have such responsibilities.
Finally, the corporation needs capital to use in production, and it is willing to pay a fair interest or equity rate to obtain the money. Consumers—who are also shareholders—are involved in the capital market when they agree to supply equity capital at their required rate of return. Consumers also supply credit to companies either directly through primary debt markets or indirectly through financial intermediaries (banks and similar institutions) whenever they can earn their required rate of return. If these required returns equal the
Appendix A to the Introduction: Private Enterprise and the Market Economy 12
Figure A−1
Linkages in the Marketplace
Note: Figures and tables in this book are based on the authors' information and calculations.
rates the company is willing to pay for the capital, they are equilibrium interest or equity rates.
In this scheme consumers, or members of society in general, and corporations interact simultaneously in all three markets. In some product markets, prices are relatively close to their equilibrium level, but this is not necessarily the case in other product markets. Generally, if prices are not constrained artificially, the closer the product or service is to being a pure commodity, or the closer it is to a condition of zero or negative growth in total market demand for the product or service, the closer the price is to an equilibrium level and vice versa.
The interaction between consumers and the enterprise in the labor markets is in many ways the most direct of the three linkages. Workers sell their labor services to earn money. The wages they earn create the means by which goods and services produced by the companies can be purchased.
Capital or financial markets are considered to be efficient in most Western countries, meaning that the interest rates or equity rates reflect true equilibrium conditions. In Appendix B to the Introduction we look more closely into the relationship between consumers and companies within the context of the capital markets.
Stakeholders
These complexities of the competitive marketplace result in a highly integrated economy. Perturbations in one area of economic activity have implications throughout the larger economy, and, as environmental conditions
Stakeholders 13
change, the task of a company's management team becomes more challenging. In developing strategies and plans for the future, managers must deal with many different economic agents and be able to forecast how they can affect the corporation and its fortunes.
Who are these agents with an interest in the fortunes of the corporation? The broad answer is everyone who comes into contact with the corporation or whose own wealth is affected by the actions of the company. On the input side are the various suppliers who sell goods and services to the corporation—the suppliers of raw materials for the production process, the suppliers of technology or production assets, the suppliers of both debt and equity capital, and the suppliers of services such as insurance, auditing, utilities, janitorial assistance, credit reporting, and labor, among others. In other words, many different groups within society, either directly or indirectly, depend on the continued existence of the company for all or part of their own welfare.
On the output side are the customers of the corporation, both domestic and foreign. Additionally, local
governments depend on the corporation for tax revenues to support city services, and local merchants depend on business from the employees of the company. Other enterprises that make complementary products are also interested in the corporation's continued success. Therefore, it is easy to identify many different groups with an interest in the continued success of the corporation. These groups are called stakeholders in the corporation, and astute managers realize their importance to the company and its future.
If any of the stakeholders feel cheated or are ignored by the corporation, they may be in a position to take actions that decrease the value of the company. Suppliers can increase input prices or refuse to deal with the company.
Customers can boycott the products made by the corporation. Local communities can increase the taxes imposed on the company. In other words, the company can be hurt if it does not pay attention to the needs and desires of all stakeholders. It is still valid to assert that the objective of management should be to maximize the value of the corporation for the benefit of the owner−shareholders, but the prescription of value maximization must be interpreted as a constrained optimization because of the needs of the other stakeholders. In other words, all other stakeholders must be satisfied to some minimum level before attention can be turned to maximizing the benefits flowing to the shareholders.
This suggests that there is a balance of power between the corporation and its various stakeholders that must be considered when setting strategic operating plans. Some stakeholders may be very powerful and in a strong bargaining position. Others might be weak. In theory, though, to operate effectively and thereby to maximize value, all of the stakeholders must be satisfied that their dealings with the corporation are fair and equitable. The corporation must also be satisfied that it has received the best terms possible. Only
after this condition is met as a minimum can management start to find other means for increasing value for the shareholders without degrading the position of other stakeholders.
Ownership of Corporations
To clarify what it means to be a shareholder of a corporation in a country with a well−functioning capital market, we need to specify how a shareholder receives compensation from the corporation and how ownership changes hands.
Methods for Compensating Shareholders
There are two primary ways that enterprises can transfer value to the owner−shareholders. Both are based on the net income earned by the company during an accounting period, but they differ in terms of the mechanism. The direct method is for the company to take part of the income earned during the period and pay it out to the
shareholders as a cash dividend.1 Of course, the enterprise must have sufficient cash money to make the dividend
Ownership of Corporations 14
payment. Once the payment is made, the money is not available for any other purpose.
The second method for transferring value from the corporation to the shareholder is indirect. Instead of paying out all income from the current period as a cash dividend, the company keeps some of the money and invests it in new assets. As long as these asset investments earn a sufficiently high rate of return, income in the future will rise and the company will be able to pay an even higher cash dividend than it would if it did not make the new
investment. This higher future dividend payment is valuable to shareholders, so the value of the stock should increase assuming that it is traded in a reasonably efficient market. If the shareholder prefers cash today, the share of stock can be sold for a higher price, and the extra "profit" on the sale should be at least equivalent to the cash dividend. Notice that for this second transfer method to work, an efficient capital market is required. More details about such a market are given in Appendix B to the Introduction.
Types of Stock Markets
Equity investment in Central and Eastern Europe is a new activity, and some confusion still exists about the mechanism by which stock changes hands in a "stock market." A major reason for the confusion is that the difference between a primary market and a secondary market has not been made clear. In most of the privatization programs in the region, whether the transfers are by voucher or by cash, the government was the original "owner"
of the stock, and individuals purchased the shares from the government. The company itself usually received no money from this transaction.
As shown in the vertical transaction section in Figure A−2, this exchange is in the secondary capital market. A secondary market is one in which a financial security owned by an individual or by an entity other than the issuing company is transferred to a new
1 Depending on the country and provisions in the Corporate Charter and various other financial contracts, it may be possible to pay cash dividends not only out of income from the current period, but also from income in past periods that was retained by the company.
owner at a mutually agreeable price.2 The corporation is not involved in this transaction (other than changing the identity of the owner on the stock register), and no money enters or leaves the corporation.
Types of Stock Markets 15
Figure A−2
Primary and Secondary Equity Markets
On the other hand, a primary capital market is used when a company wants to sell new or unseasoned stock to investors. The investor pays the money for the stock directly to the issuing corporation, and it is recorded in the books of the company as an increase in
2 If the issuing company purchases its own stock in the secondary market, the stock becomes what is known in some jurisdictions as treasury stock. The company can then sell treasury stock to someone else in a secondary market transaction. Note that in some countries it is illegal for a company to repurchase its own stock in this manner, so managers should check local laws to verify its legality.
equity capital contributed by investors and also as an offsetting increase in cash. This stock purchase is shown in the horizontal transaction section in Figure A−2. Once the original purchaser of the stock receives the shares from the corporation, the stock can be resold to someone else.3 This would be a secondary market transaction.
Should the corporation care about its stock price in the secondary market? It is not a party to secondary market transactions and can neither gain nor lose on stock sales. On the other hand, if the transaction is in the primary market, the corporation receives the money and strongly prefers a high stock price. There is a linkage between the two markets: new stock issues (primary market) cannot be placed in the market at a higher price than seasoned stock sells for. Therefore, by maintaining a high stock price in the secondary market, the company preserves the flexibility to issue new stock at a high price if the need for such an action arises in the future. If the stock is not traded in a market, management should still want the value per share to be as high as possible for the same reason.
Types of Stock Markets 16
3 This right to resell the stock quickly might not exist depending on local law and provisions in the Corporate Charter.
Appendix B to the Introduction:
The Role of Capital Markets in a Market Economy
One of the most substantive changes occurring in the ex−socialist countries as they transform themselves into competitive market economies is the emergence of embryonic financial markets. These markets are not superfluous appendages of ''capitalism." Rather, they are at the very heart of the market system.
Financial markets play a vital role in an economy in which private institutions exercise extensive economic control. They are also a primary device by which individuals signal their views on the allocation of resources in the economy and adjust their pattern of consumption and investment over time to coincide with their personal preferences. The existence of financial markets both improves the economic efficiency of resource allocations and increases the welfare and satisfaction of individuals in the society.
Financial Market Transactions
The model presented here is necessarily simple, but the ideas developed are robust in the real world of business.
We start by assuming two periods−—today and one year from today. The model is readily expandable to include more periods. A representative consumer has discretionary income of 500 today, after all necessary expenditures have been made, and will receive 600 more in one year (again, after all necessary expenditures). These amounts are referred to as the initial endowment and represent discretionary income that can be used for many purposes, depending only on the desires of the individual. In Figure B−l, the X axis represents today, the Y axis one year from today, and the point C is the ordered pair representing 500 received today and 600 to be received in one year.
If there were no financial marketplace in which to borrow or invest, the individual would be restricted to a maximum consumption today of 500, with an additional 600 (plus anything not spent today and carried over until next year) one year from now. If the person needed 700 today to buy a car, or for some other purpose, there would be no way to obtain the extra 200. Similarly, the only way to have more than 600 next year is to save money from the allocation today and defer consumption until that time. In this economy, consumption in any given period is tied closely to the wages earned in the period. It is very difficult to consume more than the current salary without advance planning (saving in prior periods).
Let us now assume that a financial market is introduced into the economy. Individuals can participate in this market either as borrowers or lenders (investors). The rate of interest charged or paid is the same for each, 20 percent. The endowment of the individual, given by the point C, plots on a straight line, the slope which is the negative of one plus the rate of interest. This line is called the Financial Market Line. If the individual decided not to consume anything this period, the entire endowment of 500 received today could be invested at 20 percent for one year, and it would increase in value to 600 by the end of
Appendix B to the Introduction: The Role of Capital Markets in a Market Economy 17
Figure B−1
The Financial Market Line
the year (500 x 1.2 = 600). If this investment is added to next year's endowment of 600, the total amount available for consumption in one year would be 1,200. The intersection of the Financial Market Line with the Y axis is at 1,200, the maximum level of consumption in one year given the initial endowment and the decision not to consume anything today.
On the other hand, if the individual decided not to consume anything one period from now and, instead, wanted to consume as much as possible today, an amount could be borrowed today at an interest rate of 20 percent. The 600 to be received in one year would then be used to repay the loan with interest. The maximum borrowing today would be 600/1.2 = 500. Adding this amount to today's endowment of 500 gives a maximum level of current consumption of 1,000, assuming that consumption one year from now will be zero. The Financial Market Line crosses the X axis at the point 1,000. Clearly, the Financial Market Line represents the locus of all possible pairs of current year's and next year's consumption, given the opportunity to borrow or lend at an interest rate of 20 percent.
Notice that the Financial Market Line is really a family of parallel lines representing financial market transaction possibilities at a given interest rate for different initial endowments. For instance, if the interest rate is 20 percent and the initial endowment is 600 today and 720 in one year, a Financial Market Line with a slope of −1.2 would pass through the ordered point (600, 720) point D. This line would have the same interpretation as the original line.
By borrowing or lending, the individual can attain any point on the relevant Financial Market Line. The question becomes: which point is the best possible combination of consumption today and consumption one year from now for this specific person? Some persons will surely be net borrowers, consuming more today than their endowment of 500 at the expense of lower consumption one year from now. Others will want to forgo some
current consumption and invest part of their endowment to augment spending power next year. How is the choice made?
Appendix B to the Introduction: The Role of Capital Markets in a Market Economy 18
To answer this question, we need to introduce personal preferences into the graph. This is done by way of a concept called an indifference curve. Figure B−2 portrays a family of indifference curves for a particular individual. Again, the X axis represents consumption today, and the Y axis is consumption in one year.
Indifference curves for a single individual cannot cross. (Because each person will have a unique set of preferences as given by his or her indifference curves, curves for different individuals can cross.) In Figure B−2, the three points labeled A, B, and C all plot on indifference curve 1. Point A represents
consumption of 550 today and 130 in one year; B is consumption of 250 today and 300 in one year; C represents consumption of 120 today and 520 in one year. This particular individual would be just as happy with
combination A as with combination B or C. In other words, all points on an indifference curve give to the individual the same degree of satisfaction.
Point D, however, plots on the indifference curve 3. D represents the same level of current consumption as a point directly below it on indifference curve 1 but a greater level of consumption next year. Or, said in a different way, D represents the same level of consumption next year as a point beside it on curve 1 but greater current
consumption. Point D, then, is preferred to any point on curve 1. In general, higher indifference curves (farther from the origin) represent greater levels of satisfaction than lower curves, and all points on a given curve represent the same level of satisfaction.
Figure B−2
Indifference Curves
An indifference curve can be used in trying to assess which combination of current and future consumption (a point on the Financial Market Line) an individual might prefer. Figure B−3 gives the same Financial Market Line as Figure B−l, but indifference curves for two individuals, A and B, are superimposed on the graph. Because higher indifference curves (farther from the origin) represent greater levels of satisfaction, individual A can attain the maximum satisfaction at the point of tangency between her indifference curve and the Financial Market Line at a level of consumption of 700 today and 360 in one year; there is no way she can get on a higher indifference curve given the current situation. Individual B, though, has a different set of indifference curves. His maximum level of satisfaction—given by the point of tangency between his indifference curve and the Financial Market Appendix B to the Introduction: The Role of Capital Markets in a Market Economy 19
Line—is at a level of consumption of 200 today and 960 in one year. Again, there is no way he can get on a higher indifference curve either.
For both individuals, the point of the initial endowment, 500 today and 600 in one year, plots on indifference curves that are lower than the optimal points. This means that the existence of a financial marketplace has enabled both individuals to increase their level of satisfaction by engaging in financial transactions. Individual A wants to consume more today, so she borrows against future income to reach her optimal point. Individual B wants to consume more next year, so he lends (invests) part of the current period endowment to magnify his consumption possibilities next year. This ability to break the direct linkage between the amount and pattern of wages earned over time and the level of consumption over time is an important benefit of financial markets in the economy. By shifting consumption to earlier or later periods through financial market transactions, the individual consumer can attain higher levels of personal satisfaction.
Figure B−3
Optimal Investment in a Financial Market Context
Real Asset or Product Markets
To this point we have assumed that only financial market investments can be made. What happens if the individual can also invest in real asset or product markets? Assume that the ten projects listed in Table B−1 are available for investment. The resulting graph (Figure B−4) is called the Production Possibilities Curve. It is not a straight line because the projects exhibit decreasing profitability as more and more capital is invested.
Table B−l. Product Market Investment Possibilities
Project Cost now Return in
one year
Cumulative return
Rate of return
A 100 300 300 200%
B 100 220 520 120%
Real Asset or Product Markets 20
C 100 190 710 90%
D 100 120 830 20%
E 100 110 940 10%
F 100 100 1040 0%
G 100 90 1130 −10%
H 100 70 1,200 −30%
I 100 50 1,250 −50%
J 100 20 1,270 −80%
Decreasing marginal productivity of capital is an important characteristic of competitive markets. There are only so many "good" projects in terms of high profitability, so the more capital one wants to invest, the lower the profitability of the last unit of capital invested. The individual starts with 1000 available for investment today, so theoretically all ten of the projects in Table B−1 could be accepted. Also assume that financial market investments are available, and the return on such investments is 20 percent. How much should the individual invest in product market projects?
Project A has a 200 percent return, a rate much higher than what is available in the financial market. Projects B and C have returns of 120 percent and 90 percent respectively. These returns are also significantly higher than the rate earned on financial market alternatives. Projects A, B, and C are good candidates for investment and should be accepted. Project D, on the other hand, has a return of 20 percent, the exact same rate available in the financial market. Therefore, the investor is indifferent to investing in project D or in the financial market. Projects E through J have returns that are less than the return in the financial markets. No rational persons would want to invest money in these projects if they could invest in the financial market at a 20 percent return.
Real Asset or Product Markets 21
Figure B4
Production Possibilities Curve
In determining which product market investments should be accepted, the rate of return in the financial market was used as a benchmark or cutoff. No mention was made of the consumption preferences of the individual investors, and no indifference curves were shown. It was still possible, however, to determine which product market investments should be made. This benchmarking is an important role of the financial markets. Note that it was assumed that the individual started with 1,000. If the initial endowment was 500 today and 600 in one year, the 1,000 amount could be obtained by borrowing all of the 600 available next year. The rate of interest in the financial market would be 20 percent, and the capital would be invested in product market projects with return greater than or equal to 20 percent. Therefore, the individual is making extra money for consumption next year even when borrowing money to invest today in product markets.
So far we have ignored the consumption preferences of individual investors. If the indifference maps for investors A and B are superimposed on the Production Possibilities Curve in Figure B4, Figure B−5 is created. It appears that investor A would prefer a different level of investment in projects than would investor B because the points of tangency between the Production Possibilities Curve and each investor's highest indifference curve are different. But we already said that the optimal investment program was to invest 400 in projects A, B, C, and D, or the point M, and that this was determined without reference to indifference curves. How can this be?
Figure B−5
Optimal Investment in a Product Market
The solution to the apparent controversy is given in Figure B−6. Both investor A and investor B agree that the optimal level of investment in projects is as described above: invest 400 in A, B, C, and D. This level of
investment gives 600 (1,000 minus the 400 investment) available for consumption today and 830 available in one year. The Financial Market Line through this point is tangent to the Production Possibilities Curve at the point M.
It is the highest Financial Market Line attainable. That is, it is impossible to draw another parallel line farther to
Real Asset or Product Markets 22
the right that can be reached through product market investment. Both A and B are on this Financial Market Line, so they can adjust for their own personal consumption preferences by moving up or down the line to the point of tangency with their highest indifference curves (point A' for investor A and B' for investor B). These points are on higher indifference curves than the ones tangent to the original Production Possibilities Curve. Thus, the level of satisfaction for both individuals is maximized.
Figure B−6
Optimal Investment in Combined Markets
Investors A and B actually invest their money in a corporation, and the company takes this capital and makes the investment in productive assets. This is one of the most fundamental principles of free market capitalism. Look at what has happened. The corporation knows to invest in projects A, B, C, and D, and it does not have to know anything about the consumption preferences of its shareholders to make the correct project investments. It follows exactly the same investment rule regardless of the consumption preferences of the shareholders because all the shareholders want management to do exactly the same thing. They want the firm to follow an investment policy that allows them to move to the highest Financial Market Line. They can then borrow or lend on their own account (as individuals) to achieve the preferred combination of consumption today and consumption tomorrow.
This principle, the Separation Theorem, can be stated as follows:
The investment decision of the firm is separate from or can be made independently of the consumption wishes of the shareholders. In an entirely separate transaction, shareholders will adjust for themselves through borrowing or lending to achieve the optimal level and pattern of consumption once they are on the highest Financial Market Line.
Real Asset or Product Markets 23
Note that investor A invests current wealth in real assets past the point at which she wants to consume and then borrows some of it back at 20 percent to adjust for consump−
tion preferences. The extra investment earns a rate higher than 20 percent, so the tradeoff is positive for investor A. Investor B, on the other hand, invests in all profitable projects in the real market and then invests even more in the financial markets to adjust for his consumption preferences. After the fourth project, rates of return in the financial market are higher than in the real asset market. Therefore, investor B makes a shift in investment type.
What happens if borrowing and lending rates are different? As shown in Figure B−7, the Financial Market Line is composed of two segments: one for borrowing and one for lending (or investing). Investors A and B will prefer different investment strategies by the corporation because they face different financial market lines and the separation theorem breaks down. Investor A prefers that management of the corporation invest less in real projects because her financial market line has a steeper slope, representing a borrowing rate higher than 20 percent. Investor B, on the other hand, prefers greater investment in real assets than A because his financial market line has a flatter slope, representing a lending rate lower than 20 percent.
Fortunately, for most corporations and investment funds, the borrowing and lending rates are nearly equal. The spread is wider for individuals at the retail level, but the difference does not tend to be so great that it introduces serious distortions. For all intents and purposes the gap in Figure B−7 between points A and B is very small and can safely be ignored.
Figure B−7
Breakdown of the Separation Theorem
Conclusion
This discussion has presented several important decision rules for corporate management to follow. Consider Figure B−6. Point M, the point of tangency between the Production Possibilities Curve and the Financial Market
Conclusion 24
Line, is the optimum level of investment in productive assets. The decision rule we used to make this assessment is well known in economics: invest in projects until the return on the last project exactly equals the cost of the last unit of capital acquired to make the investment. In other words, invest in real projects until marginal return equals marginal cost. This decision rule is sometimes referred to as the Internal Rate of Return or IRR rule in project evaluation analysis.
Another decision rule is used extensively and has a particularly strong intuitive appeal. The intersection of the Financial Market Line and the X axis represents current wealth. The obligation of management is to move the point of intersection as far to the right as possible, thereby maximizing the current wealth of the shareholders. In other words, management should invest in projects until the highest Financial Market Line is obtained. This is the Net Present Value or NPV rule.
A question must be asked and answered by the 3E Company management when it allocates resources. The
question is: Can the 3E Company make a reasonable profit serving the market need addressed by this allocation of scarce resources? Only if the answer is yes should the company proceed with the project. Now we are able to be more specific about what is meant by the phrase "reasonable profit." The project in this example is one of the alternatives on the Production Possibilities Curve. A "reasonable profit" means that acceptance of the project moves the Financial Market Line to the right. That is, the net present value of the project is positive or the internal rate of return of the project exceeds the rate of return in the financial market. This topic will be explored in greater depth later in the book.
1—
The Time Value of Money, Risk, and Rates of Return
Most textbooks on financial management presume that the reader already has had previous training in
microeconomics and accounting. Therefore, with little or no comment these books pass over many ''introductory"
topics. We do not believe that this presumption is reasonable for managers and students in the ex−socialist countries of Central and Eastern Europe. While a few readers may have some knowledge of the introductory topics, the vast majority probably have little more than a passing familiarity with these subjects. Therefore, the first two chapters of this book are intended to acquaint the reader with some fundamentals of financial
management and accounting.
Throughout this book the terms "rate of return" and "risk" are used to define the economic characteristics of decisions that must be made by company managers. Intuitively, most people probably have some notion of what these terms mean, and intuition is often sufficient to stimulate understanding of the issues. However, one of the most fundamentally important topics we will develop here, the concept of money having a "time value," depends greatly upon a precise appreciation of the economic meaning of these terms. For this reason, we explain at the outset the theoretical underpinnings of these concepts as they are used in financial economics.
The decision models developed in the book are based on two fundamental ideas:
I. Never take a risk unless you receive adequate compensation for taking it.
II. Never compare two amounts of money that occur at different points in time without allowing for the time value of money.
This chapter is devoted to an explanation of these two fundamental theorems of finance—why they are valid and exactly what they imply about the management of a business enterprise.
1— The Time Value of Money, Risk, and Rates of Return 25