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Some Notations
ADF Annuity discount factor MVA Market value added
APR Annual percentage rate MVR Market value at risk
APV Adjusted present value NOPAT Net operating profit after tax
bU Levered beta (also called equity or NOPLAT Net operating profit less adjusted tax
market beta) NPV Net present value
bL Unlevered beta (also called asset beta) P Price of a bond, a stock, or a put option
C Call price PBR Price-to-book ratio
CAPM Capital asset pricing model PI Profitability index
CAPEX Capital expenditures PER Price earnings ratio
CF Cash flow PPP Purchasing power parity
CFE Cash flow to equity holders PV Present value
CML Capital market line rij Correlation coefficient between asset i
CP Coupon payment (of a bond) and asset j returns
Cov 1 Ri, Rj 2 Covariance between asset i and asset j RF Risk-free rate
returns RM Return on the market portfolio
D Debt value ROCE Return on capital employed
DCF Discounted cash flow ROE Return on equity
D Option’s delta or hedge ratio ROIC Return on invested capital
DDM Dividend discount model SGR Self-sustainable growth rate
DF Discount factor si Standard deviation of asset i returns
DPS Dividend per share (volatility)
E Equity value s2i Variance of asset i returns (variability)
EAT Earnings after tax sij Covariance between asset i and asset j
EBIT Earnings before interest and tax returns
EBITDA Earnings before interest, tax, SML Security market line
depreciation and amortization T Time in years
EIL Efficient investment line TC Corporate tax rate
EPS Earnings per share TV Terminal value
E 1 Ri 2 Expected return of asset i VE Value of the firm’s equity (same as E)
EV Enterprise value VL Value of the firm with debt (levered
EVA® Economic value added value)
F Face value of a bond VU Value of the firm without debt
(unlevered value)
FCF Free cash flow
Var 1 Ri 2 Variance of asset i returns
IPO Initial public offering
(same as s2i )
ITS Interest tax shield
WCR Working capital requirement
kD Cost of debt
WACC Weighted average cost of capital
kE Cost of equity
X Exercise or strike price of an option
LBO Leverage buyout
y Yield to maturity (of a bond)
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Some Useful Formulas
1. Discount factor (Chapter 2, equation 2.3)
Value of $1 to be received at time T, discounted to the present at the rate k
$1 $1 T
DFT,k 5 5¢ ≤ 5 $1 3 1 1 1 k 2 2T
1 11k 2 T
11k
2. Present value (Chapter 2)
Value today of a T-year cash-flow stream discounted at rate k
PV 5 3 CF1 3 DF1,k 4 1 . . . 3 CFt 3 DFt,k 4 1 . . . 1 3 CFT 3 DFT,k 4

3. Present value of a perpetuity (Chapter 2, equation 2.6)
The present value of an infinite stream of identical cash flows discounted at rate k
CF
PV 5
k
4. Present value of a constant growing perpetuity (Chapter 2, equation 2.9)
Present value, at rate k, of a perpetuity growing at the constant rate g where the
cash flow at the end of the first year is CF1
CF1
PV 5 with k . g
k2g
5. Present value of an annuity (Chapter 2, equation 2.11)

Present value of a T-year annuity at a rate k with a cash flow CF
PV 5 CF 3 ADFT,k with
1 1
ADFT,k 5 B1 2 R
k 1 11k 2 T
6. Sharpe ratio of asset i (Chapter 3, equation 3.8)
E 1 Ri 2 2 RF
Sharpe ratio of asset i 5
si
7. Beta coefficient of stock i (Chapter 3, equation 3.11)
Cov 1 Ri, RM 2 riMsisM si

5 bi 55 riM ¢ ≤
Var 1 RM 2 2
sM sM
8. Capital asset pricing model (Chapter 3, equation 3.13a, Chapter 10,
equation 10.11a and Chapter 12, equation 12.10)
E 1 Ri 2 5 RF 1 3 E 1 RM 2 2 RF 4 b i
9. Invested capital (Chapter 4, equation 4.5)
Invested capital 5 Cash 1 Working capital requirement 1 Net fixed assets
10. Capital employed (Chapter 4, equation 4.6)

Capital employed 5 Short-term debt 1 Long-term debt 1 Owners’ equity
Some Useful Formulas
11. Working capital requirement (Chapter 4, equation 4.7)
WCR 5 3 Accounts receivable 1 Inventories 1 Prepaid expenses 4

2 3 Accounts payable 1 Net accruals 4
12. Earnings before interest, tax, depreciation, and amortization (Chapter 4,
equation 4.10)
EBITDA 5 EBIT 1 Depreciation expense 1 Amortization expense
13. Free cash flow (Chapter 4, equation 4.15)
FCF 5 EBIT 1 1 2 Tc 2 1 Depreciation expense
2 DWCR 2 Capital expenditures 1 net of disposals 2
14. Return on equity (Chapter 6, equation 6.1)
Earnings after tax
ROE 5
Owners’ equity
15. Return on invested capital before tax (Chapter 6, equation 6.4)
EBIT EBIT Sales

ROICBT 5 5 3
Invested capital Sales Invested capital
16. The structure of a firm’s return on equity (Chapter 6, equation 6.9)
EBIT Sales EBT Invested capital EAT

ROE 5 3 3 3 3
Sales Invested capital EBIT Owners’ equity EBT
17. Self-sustainable growth rate (Chapter 6, equation 6.12)
SGR 5 Profit retention rate 3 Return on equity
18. Net present value (Chapter 7)

CF1 CF2 CFt CFT
NPV 1 k,T 2 5 2CF0 1 1 1 ... 1 1 ... 1
1 11k 2 1 1 11k 2 2 1 11k 2 t 1 11k 2 T
5 2CF0 1 a
T
CFt
t5 1 1 11k 2
t
19. Bond price (Chapter 10, equation 10.2)

CP1 CP2 CPT 1 F
1 P5
1 ... 1
1 11y 2 1 11y 2 2
1 11y 2 T
20. Share price (Chapter 10, equation 10.9)
DPS1 DPS2 DPSt
P5 1 1 ... 1 1 ...
1 11kE 2 1 11kE 2 2 1 11kE 2 t
21. Constant dividend growth model (Chapter 10, equation 10.10)

DPS1
P5
kE 2 g
22. Enterprise value and Equity value (Chapter 10, equation 10.13)
Enterprise Value (EV) 5 Equity Value 1 Debt 2 Cash and other financial assets
Equity Value 1 VE 2 5 Enterprise Value 1 EV 2 1 Cash 2 Debt
23. Equity (levered) beta (Chapter 12, equation 12.6)
Debt
bequity 5 basset B1 1 R
Equity
24. Weighted average cost of capital (Chapter 12, equation 12.12)

D E
WACC 5 kD 1 1 2 TC 2 1 kE
E1D E1D
25. Interest tax shield (Chapter 13, equation 13.3)
ITS 5 TC 3 kD 3 D
26. Market value of a levered firm (Chapter 13, equation 13.4)

VL 5 VU 1 PVITS
27. Market value at risk (Chapter 15, equation 15.1)
MVR 5 3 Reduction in the firm’s value if the risk will occur 4

3 3 Probability that the risk will occur 4
28. Put-call parity relationship (Chapter 16, equation 16.5)
P0 5 C0 1 Xe2R T 2 S0 F
29. Black-Scholes option pricing formula (Chapter 16, equation 16.6 and 16.7)
C0 1 call option 2 5 S0N 1 d1 2 2 Xe2R TN 1 d2 2 F
P0 1 put option 2 5 Xe2R T 3 1 2 N 1 d2 2 4 2 S0 3 1 2 N 1 d2 2 4

F
30. Market value added (Chapter 18, equation 18.1)
Market value added 1 MVA 2 5 Market value of capital 2 Capital employed
31. Return on invested capital (Chapter 18)

NOPAT EBIT 1 1 2 TC 2
ROIC 5 5
Invested capital Invested capital
32. Economic value added (Chapter 18, equation 18.6)
EVA 5 3 Return spread 4 3 Invested capital 5 3 ROIC 2 WACC 4 3 Invested capital
Finance For Executives
Managing for Value Creation
Finance For Executives
Managing for Value Creation
sixth Edition
Gabriel Hawawini
INSEAD
Claude Viallet
INSEAD
Australia • Brazil • Mexico • Singapore • United Kingdom • United States
Finance for Executives: Managing for © 2019, Cengage Learning EMEA
Value Creation, Sixth Edition
WCN: 02-300
Gabriel Hawawini & Claude Viallet
ALL RIGHTS RESERVED. No part of this work covered by the
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ISBN: 978-1-4737-4924-5
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Printed in China by RR Donnelley

Print Number: 01 Print Year: 2019
To our spouses, children and grandchildren, with love and gratitude.
GH and CV, 2018
This edition of Finance for Executives is dedicated to the memory of

Claude Viallet, my friend, colleague and co-author.
Gabriel Hawawini, 2019
Brief Contents
part i Financial Concepts and Techniques 1
chapter 1 Financial Management and Value Creation: An Overview 1
chapter 2 The Time Value of Money 31
chapter 3 Risk and Return 53
PART ii Assessing Business Performance 99

chapter 4 Interpreting Financial Statements 99
chapter 5 Analyzing Operational Efficiency and Liquidity 153
chapter 6 Analyzing Profitability, Risk, and Growth 189
PART iii Making Investment Decisions 227

chapter 7 Using the Net Present Value Rule to Make Value-Creating
Investment Decisions 227
chapter 8 Alternatives to the Net Present Value Rule 261
chapter 9 Identifying and Estimating a Project’s Cash Flows 287
PART iV Making Financing Decisions 315

chapter 1 0 Valuing Bonds and Stocks 315
chapter 1 1 Raising Capital and Paying Out Cash 359
chapter 1 2 Estimating the Cost of Capital 411
chapter 1 3 Designing a Capital Structure 445
PART V Making Business Decisions 487

chapter 1 4 Valuing and Acquiring a Business 487
chapter 1 5 Managing Corporate Risk 531
chapter 1 6 Understanding Forward, Futures, and Options and Their
ontribution to Corporate Finance 555
C
chapter 1 7 Making International Business Decisions 609
chapter 1 8 Managing for Value Creation 653
Answers to Self-Test Questions 691
Glossary 741
Credits 763
Index 765
vi
Contents
PART i Financial Concepts and Techniques 1

chapter 1 Financial Management and Value Creation: An Overview 1
The Key Question: Will Your Decision Create Value? 2
The Importance of Managing for Value Creation 3
The Saturn Story 4
The Fundamental Finance Principle 5
Measuring Value Creation with Net Present Value 5
Only Cash Matters 6
Discount Rates 6
A Proposal’s Cost of Capital 7
Applying the Fundamental Finance Principle 8
The Capital Budgeting Decision 8
The Payout Policy 10
The Capital Structure Decision 11
The Business Acquisition Decision 11
The Foreign Investment Decision 12
The Role of Financial Markets 12
The Equity Market 13
The Vioxx Recall 14
External Versus Internal Financing 15
The Business Cycle 15
HLC’s Financial Statements 17
The Balance Sheet 17
A Variant of the Standard Balance Sheet: The Managerial
Balance Sheet 19
The Income Statement 20
How Profitable Is the Firm? 21
The Profitability of Equity Capital 21
The Profitability of Invested Capital 22
How Much Cash Has the Firm Generated? 22
Sources and Uses of Cash 23
The Statement of Cash Flows 23
How Risky Is the Firm? 23
Has the Firm Created Value? 25
The Role of the Chief Financial Officer 26
vii
viii Finance For Executives
Key Points 26
Further Reading 27
Self-Test Questions 27
chapter 2 The Time Value of Money 31

Present Values and Future Values 32
Compounding 33
Discounting 34
Using a Financial Calculator to Solve Time Value of
Money Problems 35
Using a Spreadsheet to Solve Time Value of
Money Problems 36
Interest Rate Quotation and Calculation 36
The Annual Percentage Rate Versus the Effective Annual Rate 37
Nominal Versus Real Rates 38
The Present Value of a Stream of Future Cash Flows 38
The Net Present Value (NPV) Rule 39
The Internal Rate of Return (IRR) Rule 39
The Present Value of a Perpetual Cash-Flow Stream 40
The Present Value of a Growing Perpetuity 41
The Present Value of a Standard Annuity 42
The Present Value of a Growing Annuity 44
The Future Value of an Annuity 46
Key Points 47
Appendix 2.1 Proof of Formula 2.9 and Formula 2.6 49

Further Reading 49
Review Questions 50
chapter 3 Risk and Return 53

Measures of Return 54
Realized Returns 54
Expected Return 55
Annualized Returns 55
Measures of Risk 55
Measuring Risk with the Variance of Returns 55
Measuring Risk with the Standard Deviation of Returns 56
Variance versus Standard Deviation 56
Annualized Measures of Risk 56
Return Distributions 57
Contents ix
Mean-Variance Analysis 57
Attitudes Toward Risk 60
Evidence from Financial Markets 61
Combining Two Stocks into a Portfolio 61
Portfolio Expected Return 63
Portfolio Risk and Correlations 63
Diversification Can Reduce Risk and Raise Return 65
The Opportunity Set of a Two-Stock Portfolio 65
The Optimal Portfolio of a Risk-Averse Investor 68
Changes in the Correlation Coefficient 68
Combining More Than Two Stocks into a Portfolio 68
Portfolio Expected Return 69
Portfolio Risk and Diversification 69
Portfolio Diversification in Practice 72
Firm-Specific Risk versus Market Risk 73
The Opportunity Set with More Than Two Stocks 74
Optimal Portfolios when there is a Riskless Asset 75
The Efficient Investment Line 75
The Sharpe Ratio 76
Making Optimal Investment Choices 77
The Market Portfolio and the Capital Market Line 79
The Expected Return of the Market Portfolio 79
Proxies for the Market Portfolio 80
The Sharpe Ratio and the Efficiency of the Market Portfolio 80
The Capital Market Line 80
Modern Investment Management: Allocation Beats Selection 82
A Closer Look at Systematic Risk 83
Beta and the Market Model 84
Calculating Beta 84
The Properties of Beta 85
Estimated Stock Betas 85
Portfolio Beta 86
The Capital Asset Pricing Model 87
The Expected Return of an Individual Stock 87
Using the CAPM to Estimate a Company’s Cost of Equity Capital 88
Using the CAPM to Evaluate Investment Performance 89
Using the CAPM to Test the Informational Efficiency of Stock
Markets 90
Key Points 91
Further Reading 92
Appendix 3.1 How to Get the SML Equation 93

Review Questions 95
x Finance For Executives
PART ii Assessing Business Performance 99

chapter 4 Interpreting Financial Statements 99
Financial Accounting Statements 99
The Balance Sheet 100
Current or Short-Term Assets 101
Noncurrent or Fixed Assets 105
Current or Short-Term Liabilities 107
Noncurrent Liabilities 108
Owners’ Equity 110
The Managerial Balance Sheet 110
Working Capital Requirement 111
The Income Statement 114
Net Sales or Turnover 116
Gross Profit 116
Operating Profit 117
Earnings Before Interest and Tax (EBIT) 117
Earnings Before Tax (EBT) 118
Earnings After Tax (EAT) 118
Earnings Before Interest, Tax, Depreciation, and Amortization
(EBITDA) 118
Reconciling Balance Sheets and Income Statements 119
The Structure of the Owners’ Equity Account 120
Preparing a Statement of Cash Flows 122
Net Cash Flow from Operating Activities 123
Net Cash Flow from Investing Activities 125
Net Cash Flow from Financing Activities 126
Problems with the Statement of Cash Flows 127
Free Cash Flow 128
Key Points 129
Appendix 4.1 Obtaining the Net Cash Flow from Operating Activities Using
Balance Sheet and Income Statement Accounts 132
Measuring Cash Inflow from Sales 132
Measuring Cash Outflow from Operating Activities 132
Cash Outflow from Purchases 132
Cash Outflow from SG&A and Tax Expenses 133
Cash Outflow from Net Interest Expense 134
Net Cash Flow from Operating Activities 134
Contents xi
Appendix 4.2 Specimen Financial Statements 136

The GlaxoSmithKline (GSK) Financial Statements 136
GSK’s Balance Sheets and Managerial Balance Sheets 136
GSK’s Balance Sheets 136
Gsk’s Managerial Balance Sheets 139
GSK’s Income Statements 140
GSK’s Statements of Cash Flows 142
Further Reading 144
Review Questions 148
chapter 5 Analyzing Operational Efficiency and Liquidity 153

The Structure of the Managerial Balance Sheet 154
The Three Components of a Firm’s Invested Capital 154
The Two Components of a Firm’s Capital Employed 158
The Structure of OS Distributors’ Managerial Balance Sheet 158
The Matching Strategy 158
A Measure of Liquidity Based on the Funding Structure of Working
Capital Requirement 160
Improving Liquidity through Better Management of the
Operating Cycle 163
The Effect of the Firm’s Economic Sector on Its Working Capital
Requirement 163
The Effect of Managerial Efficiency on Working Capital Requirement 165
The Effect of Sales Growth on Working Capital Requirement 167
Traditional Measures of Liquidity 168
Net Working Capital 168
The Current Ratio 170
The Acid Test or Quick Ratio 171
Key Points 171
A p p e n d i x 5 . 1 Financing Strategies 173
A p p e n d i x 5 . 2 The GlaxoSmithKline Liquidity and Operational Efficiency 176

Gsk’s Liquidity Position 176
Gsk’s Management of the Operating Cycle 177
Further Reading 179
xii Finance For Executives
chapter 6 Analyzing Profitability, Risk, and Growth 189

Measures of Profitability 190
Return on Equity 190
Measuring Return on Equity 190
The Effect of Operating Decisions on ROE 191
The Effect of Financing Decisions on Return on Equity 197
The Incidence of Taxation on Return on Equity 199
Putting It All Together: The Structure of a Firm’s Profitability 200
The Structure of ROE Across Industries 202
Other Measures of Profitability 203
Earnings Per Share (EPS) 203
The Price-to-Earnings Ratio (P/E) 203
The Market-to-Book Ratio 204
Financial Leverage and Risk 204
How Does Financial Leverage Work? 205
Two Related Caveats: Risk and the Ability to Create Value 206
Self-Sustainable Growth 207
Key Points 211
A p p e n d i x 6 . 1 Glaxosmithkline�s Profitability 213

GSK�s Profitability Structure 213
Return on Equity 213
The Effect of Operating Margin on GSK’s Operating Profitability 213
The Effect of Invested Capital Turnover on GSK’s Operating
Profitability 217
The Effect of GSK’s Financial Policy on Its Return on Equity 218
The Effect of Taxation on GSK’s Return on Equity 219
Further Reading 219
PART iii Making Investment Decisions 227

chapter 7 Using the Net Present Value Rule to Make Value-Creating
Investment Decisions 227
The Capital Investment Process 228
Would You Buy This Parcel of Land? 230
The Alternative Investment 230
The Opportunity Cost of Capital 231
The Net Present Value Rule 232
A One-Period Investment 232
A Two-Period Investment without an Intermediate
Cash Flow 234
Contents xiii
A Two-Period Investment with an Intermediate Cash Flow 235

Multiple-Period Investments 236
Applying the Net Present Value Rule to a Capital Investment
Decision 237
Why the NPV Rule is a Good Investment Rule 238
NPV Is a Measure of Value Creation 239
NPV Adjusts for the Timing of the Project’s Cash Flows 240
NPV Adjusts for the Risk of the Project’s Cash Flows 240
NPV Is Additive 244
Special Cases of Capital Budgeting 246
Comparing Projects of Unequal Size 246
Comparing Projects with Unequal Life Spans 248
Limitations of the Net Present Value Criterion 251
Managerial or Real Options Embedded in Investment Projects 251
Dealing with Managerial Options 253
Key Points 254
Further Reading 256
chapter 8 Alternatives to the Net Present Value Rule 261

The Payback Period 261
The Payback Period Rule 262
Why Do Managers Use the Payback Period Rule? 265
The Discounted Payback Period 267
The Discounted Payback Period Rule 268
The Discounted Payback Period Rule versus the Ordinary Payback
Period Rule 269
The Internal Rate of Return 270
The IRR Rule 271
The IRR Rule May Be Unreliable 273
Why Do Managers Usually Prefer the IRR Rule to the NPV Rule? 276
The Profitability Index 277
The Profitability Index Rule 277
Use of the Profitability Index Rule 278
The Average Accounting Return 279
The Average Accounting Return Rule 280
Key Points 280
Further Reading 282
xiv Finance For Executives
chapter 9 Identifying and Estimating a Project’s Cash Flows 287

The Actual Cash-Flow Principle 287
The With/Without Principle 288
The Designer Desk Lamp Project 290
Identifying a Project’s Relevant Cash Flows 292
Sunk Costs 292
Opportunity Costs 293
Costs Implied by Potential Sales Erosion 293
Allocated Costs 294
Depreciation Expense 294
Tax Expense 294
Financing Costs 295
Inflation 296
Estimating a Project’s Relevant Cash Flows 297
Measuring the Cash Flows Generated By a Project 298
Estimating the Project’s Initial Cash Outflow 299
Estimating the Project’s Intermediate Cash Flows 303
Estimating the Project’s Terminal Cash Flow 304
Should SMC Launch the New Product? 305
Sensitivity of the Project’s NPV to Changes in the Lamp Price 306
Sensitivity of NPV to Sales Erosion 306
Key Points 307
Further Reading 308
PART iV Making Financing Decisions 315

chapter 1 0 Valuing Bonds and Stocks 315
What Are Bonds and Common Stocks? 316
Bond Features and Terminology 316
Common Stock Features and Terminology 317
The Discounted Cash Flow (DCF) Model 318
Valuing Bonds 320
Finding the Price of a Bond when its Yield Is Known 320
How Changes in Yield Affect Bond Prices 321
Bond Price versus Face Value 322
Finding the Yield of a Bond When Its Price Is Known 322
The Market Yield of a Bond Is the Cost of Debt to the Firm 323
Price Quotation and Yield Conventions 323
The Case of Zero-Coupon Bonds 324
The Case of Perpetual Bonds 326
A Closer Look at Bond Yields snd Risk 327
Risk Is the Major Determinant of a Bond’s Yield 327
Credit Risk, Credit Ratings, and Credit Spreads 327
Contents xv
The Term Structure of Interest Rates 329

Finding the Price and the Yield of a Bond If the
Spot Rates are Known 333
Interest-Rate Risk 334
Duration as a Measure of Interest-Rate Risk 335
Valuing Common Stocks 336
Valuation Based on the Dividend-Discount Model (DDM) 336
Valuation Based on Discounted Free Cash Flows 339
Valuing PEC with the Discounted Free Cash Flow Model 341
Valuation Based on Discounted Cash Flows to Equity Holders 343
Comparing the Three Discounted Cash Flow Models 345
Valuation Based on Comparable Firms 345
Direct Valuation of a Firm’s Equity Based on the
Price-to-Earnings Ratio 346
Direct Valuation of a Firm’s Equity Based on the Price-to-Book
Ratio 347
Indirect Valuation of a Firm’s Equity Based on the EV-to-EBITDA
Ratio 347
Key Points 348
A p p e n d i x 1 0 . 1 The Properties of Duration 350

Further Reading 353
chapter 1 1 Raising Capital and Paying Out Cash 359

Estimating the Amount of Required External Funds 360
The Financial System: Its Structure and Functions 364
Direct Financing 364
Indirect or Intermediated Financing 364
Securities Markets 367
How Firms Issue Securities 371
Private Placement 371
Public Offerings 371
Raising Debt Capital 375
Borrowing through Bank Loans 376
Borrowing through Lease Agreements 376
Borrowing by Issuing Short-Term Securities 379
Borrowing by Issuing Corporate Bonds 379
Raising Equity Capital 383
Preferred Stocks 383
Tracking Stock 385
Equity Warrants 385
Contingent Value Rights 385
Distributing Cash to Shareholders 386
Observed Payout Policies 386
xvi Finance For Executives
How and Why Firms Pay Dividends and Buy Back their Shares 390
How Firms Pay Dividends 391
How Firms Repurchase their Shares 391
Differences Between Dividend Payments and Share Repurchases 392
Does a Firm Payout Policy Affect Its Share Price and the Wealth of Its
Shareholders? 394
Paying an Immediate Special Dividend of $250 Million 396
Buying Back $250 Million of Shares in the Open Market 397
Issuing $100 Million of New Equity to Pay an Immediate Dividend of
$350 Million 398
Investing $250 Million in a Project 399
Payout Policy Is Irrelevant in a Perfect Market Environment as Long as the
Firm’s Investing and Financing Policies do not Change 399
Payout Policy with Market Imperfections 400
Key Points 402
Further Reading 405
chapter 1 2 Estimating the Cost of Capital 411

Identifying Proxy or Pure-Play Firms 412
Estimating the Cost of Debt 413
Estimating the Cost of Equity 415
Estimating the Cost of Equity Using the Dividend-Discount Model 415
Estimating the Cost of Equity Using the Capital Asset Pricing Model 417
Estimating the Cost of Capital of a Firm 426
What Is a Firm’s Cost of Capital? 426
The Firm’s Target Capital Structure 427
The Firm’s Costs of Debt and Equity 429
Summary of the Firm’s WACC Calculations 430
Estimating the Cost of Capital of a Project 430
The Project’s Risk Is Similar to the Risk of the Firm 430
The Project’s Risk Is Different from the Risk of the Firm 431
Three Mistakes to Avoid When Estimating a Project’s Cost of
Capital 434
Key Points 438
Further Reading 439
chapter 1 3 Designing a Capital Structure 445

The Capital Structure Decision in a World without Corporate Income
Tax and Financial Distress Costs 446
Effects of Borrowing on the Firm’s Profitability (No Corporate Income Tax
and No Financial Distress Costs) 446
Contents xvii
Understanding the Trade-Off Between Profitability and Risk 449

Effect of Borrowing on the Value of the Firm’s Assets and Its Share Price
(No Corporate Income Tax and No Financial Distress Costs) 450
Effect of Borrowing on the Firm’s Cost of Capital (No Corporate Income
Tax and No Financial Distress Costs) 453
The Capital Structure Decision in a World with Corporate Income Tax
but without Financial Distress Costs 455
Effect of Borrowing on the Value of a Firm’s Assets (with Corporate
Income Tax and No Financial Distress Costs) 456
Effect of Borrowing on the Firm’s Market Value of Equity (with Corporate
Income Tax and No Financial Distress Costs) 460
Effect of Borrowing on the Firm’s Share Price (with Corporate Income Tax
Effect of Borrowing on the Cost of Capital (with Corporate Income Tax
The Capital Structure Decision when Financial Distress is
Costly 464
Formulating a Capital Structure Policy 467
A Closer Look at the Trade-Off Model of Capital Structure 467
Factors Other Than Taxes That May Favor Borrowing 470
Factors Other Than Financial Distress Costs That May Discourage
Borrowing 473
Is There a Preference for Retained Earnings? 475
Putting It All Together 476
Key Points 479
A p p e n d i x 1 3 . 1 Capital Structure and Systematic Risk (Beta) 481

How to Extract Unlevered Betas from Levered Betas 481
Case 1: The Debt-to-Equity Ratio (D/E) is Constant
Over Time 482
Case 2: The Amount of Debt (D) is Constant Over Time 482
Which Formula Should Be Used to Get Unlevered Betas? 483
Further Reading 484
PART V Making Business Decisions 487

chapter 1 4 Valuing and Acquiring a Business 487
Alternative Valuation Methods 488
Valuing a Firm’s Equity Using Comparable Firms 489
Direct Estimation of a Firm’s Equity Value Based on the Equity Value of
Comparable Firms 492
Indirect Estimation of a Firm’s Equity Value Based on the Enterprise
Value of Comparable Firms 494
xviii Finance For Executives
Valuing a Firm’s Business Assets and Equity Using the Discounted Cash
Flow (DCF) Method 496
Estimation of OS Distributors’ Enterprise and Equity Values 497
Step 1: Determination of the Length of the Forecasting Period 498
Step 2: Estimation of the Free Cash Flow from Business Assets 498
Step 3: Estimation of the Weighted Average Cost of Capital 502
Step 4: Estimation of the Terminal Value of Business Assets at
the End of Year 5 503
Step 5: Estimation of the DCF Value of Business Assets (Enterprise Value) 504
Step 6: Estimation of the DCF Value of Equity 504
Comparison of DCF Valuation and Valuation by Comparables 505
Estimating the Acquisition Value of OS Distributors 505
Identifying the Potential Sources of Value Creation in an Acquisition 505
Why Conglomerate Mergers Are Unlikely to Create Lasting Value Through
Acquisitions 508
The Acquisition Value of OS Distributors’ Equity 510
Estimating the Leveraged Buyout Value of OS Distributors 514
Estimating the Leveraged Buyout Value of Business Assets Using the
Adjusted Present Value Method (the APV Method) 516
Will OS Distributors Be Able to Service Its Debt? 520
Key Points 523
Further Reading 525
chapter 1 5 Managing Corporate Risk 531

What Is Risk? 532
Why Should Firms Manage Risk? 533
Risk Management Can Reduce Corporate Income Tax Payments 534
Risk Management Can Lower the Cost of Protection Against Risk 534
Risk Management Can Lower Financial Distress Costs 534
Risk Management Can Provide Clearer Information to Investors About the
Firm’s Core Activities 534
Risk Management Can Lower Agency Costs 534
Corporate Risk Management 535
Risk Netting 535
Cost Savings 535
Risk Policy 536
Risk Learning 536
The Risk Management Process 536
Step 1: Risk Identification 537
Step 2: Risk Measurement 545
Step 3: Risk Prioritization 546
Step 4: Risk Policy 547
Step 5: Risk Monitoring 551
Contents xix
Key Points 551

Further Reading 552
chapter 1 6 Understanding Forward, Futures, and Options and Their

Contribution to Corporate Finance 555
Forward Contracts 556
Price Risk 556
Counterparty Risk 556
Liquidity Risk 557
Futures Contracts and Markets 557
How Futures Markets Mitigate Counterparty Risk 557
How Futures Markets Mitigate Liquidity Risk 558
Available Futures Markets and Contracts 559
Hedging Risk with Futures Contracts 559
The Pricing of Forward and Futures Contracts 562
The Relationship Between the Spot Price and the Forward Price 562
The Relationship Between the Expected Spot Price and the Forward
Price 565
Option Contracts 566
Option Contracts Defined 567
Over-The-Counter (OTC) Options Versus Traded Options 567
European versus American Options 567
Option Buyers and Option Writers 568
Call Options 568
Put Options 571
The Put-Call Parity Relationship 574
Getting Option Prices with the Black and Scholes Formula 577
The Price of a European Call on a Non-Dividend-Paying Stock 577
The Price of a European Put on a Non-Dividend-Paying Stock 577
Using a Spreadsheet to Calculate the Price of European Options 577
The Price of European Options on Dividend-Paying Stocks 579
The Price of American Options 579
Response of Option Prices to Changes in Input Values 581
Implied Volatility 582
How Good Is the Black-Scholes Model? 583
Delta: A Measure of the Sensitivity of Option Prices to Changes in the
Underlying Stock Price 583
An Investment in an Option Is Always Riskier Than the Same Investment
in the Underlying Stock 584
Option-Based Investment Strategies 585
Speculating on a Rise in Stock Price with Naked Calls 585
Hedging Against a Drop in Stock Price with Protective Puts 585
Insuring Equity Portfolios 587
Writing Covered Calls to Generate Income 587
xx Finance For Executives
Collars: Covered Calls with Protective Puts 587

Hedging Stock Price Volatility with Long Straddles 587
Arbitraging Option Prices with Money Spreads or Time Spreads 588
Securities with Option Features 588
Equity as a Call Option on the Firm's Assets 588
Corporate Bonds As Risk-Free Bonds and Short Puts on the Firm’s
Assets 591
Collateralized Loans 591
Right Issues, Warrants and Contingent Value Rights 591
Callable and Convertible Bonds 592
Real Options and Strategic Investment Decisions 592
Expanding Abroad 593
Calculating the Project’s NPV with the Option Value 595
Discussion 596
Different Types of Real Options Embedded in Projects 597
Key Points 597
A p p e n d i x 1 6 . 1 The Binomial Option Pricing Model 601

Creating a Riskless Covered Call Position 601
Finding the Call Price Based on the Riskless Covered Call Position 602
Further Reading 602
chapter 1 7 Making International Business Decisions 609

The Firm’s Risk Exposure from Foreign Operations 610
Accounting, or Translation, Exposure 610
Economic Exposure 610
Managing Currency Risk 612
The Foreign-Exchange Market 613
Hedging Contractual Exposure to Currency Risk 614
Hedging Long-Term Contractual Exposure to Currency Risk with
Swaps 620
Factors Affecting Changes in Exchange Rates 622
How Differences in Inflation Rates Affect Exchange Rates: The Purchasing
Power Parity Relation 623
The Relationship between Two Countries’ Inflation Rates and Interest
Rates: The International Fisher Effect 624
How Differences in Interest Rates Affect Exchange Rates: The Interest-Rate
Parity Relation 625
The Relation between Forward Rates and Future Spot Rates 626
Putting It All Together 627
Analyzing an International Investment Project 628
The Net Present Value Rule: A Brief Review 628
Surf and Zap Cross-Border Alternative Investment Projects 629
Contents xxi
Managing Country Risk 635

Invest in Projects with Unique Fveatures 635
Use Local Sourcing 635
Choose a Low-Risk Financial Strategy 636
Design a Remittance Strategy 636
Consider Buying Insurance Against Country Risk 636
Key Points 637
A p p e n d i x 1 7 . 1 Translating Financial Statements with the Monetary/

Nonmonetary Method and the All Current Method 639
The Monetary/Nonmonetary Method 639
The All Current Method 640
Which Method Is Better? 642
A p p e n d i x 1 7 . 2 The Parity Relations 643

The Law of One Price 643
The Purchasing Power Parity Relation 644
The International Fisher Effect 644
The Interest-Rate Parity Relation 645
Strategy 1: Investment in US Dollars 645
Strategy 2: Investment in Euros 646
Further Reading 647
chapter 1 8 Managing for Value Creation 653

Measuring Value Creation 654
Estimating Market Value Added 654
Interpreting Market Value Added 657
A Look at the Evidence 658
Identifying the Drivers of Value Creation 660
Linking Value Creation to Operating Profitability, the Cost of Capital,
and Growth Opportunities 661
Only Value-Creating Growth Matters 663
Linking Value Creation to Its Fundamental Determinants 664
Linking Operating Performance and Remuneration to Value
Creation 665
Mr. Thomas Hires a General Manager 666
Has the General Manager Achieved His Objectives? 667
Economic Profits Versus Accounting Profits 669
Designing Compensation Plans That Induce Managers to Behave Like
Owners 670
xxii Finance For Executives
Linking the Capital Budgeting Process to Value Creation 671

The Present Value of an Investment’s Future EVA Is Equal to Its MVA 672
Maximizing MVA Is the Same as Maximizing NPV 672
Putting It All Together: The Financial Strategy Matrix 675
The Business Is a Value Creator but Is Short of Cash 676
The Business Is a Value Creator with a Cash Surplus 676
The Business Is a Value Destroyer with a Cash Surplus 677
The Business Is a Value Destroyer That Is Short of Cash 677
Key Points 677
A p p e n d i x 1 8 . 1 Adjusting Book Values to Estimate the Amount of Invested Equity

Capital and Operating Profit 679
Adjusting the Book Value of Equity Capital 679
Adjusting Earnings Before Interest and Tax 680
A p p e n d i x 1 8 . 2 Estimating Market Value Added (MVA) when Future Cash Flows
are Expected to Grow at a Constant Rate in Perpetuity 682
Further Reading 683
Answers to Self-Test Questions 691

Glossary 741
Credits 763
Index 765
Preface
Finance is an essential and exciting area of management that many executives want
to learn or explore in more depth. Most finance textbooks, however, are either too
advanced or too simplistic for many nonfinancial managers. Our challenge was to
write an introductory text that is specifically addressed to executives, and that is
both practical and rigorous.
The target audience includes executives directly and indirectly involved with
financial matters and financial management, which is just about every executive.
Over the past few years, several thousand managers around the world have used
most of the material in this book. The text works well in executive-development
programs – including executive masters of business administration (EMBA)

programs – and corporate finance courses for an undergraduate or MBA audience
either as a core text, where a more practical and applied emphasis is desired, or as
a companion to a theoretical text to translate theory into practice.
Finance for Executives has a number of important features:
• The book is based on the principle that managers should manage their firm’s
resources with the objective of increasing their firm’s value.
Managers must make decisions that are expected to raise their firm’s market value.
This fundamental principle underlies our approach to management. This book is
designed to improve managers’ ability to make decisions that create value, including
decisions to restructure existing operations, launch new products, buy new assets,
acquire other companies, and finance the firm’s investments.
• The book fills the gap between introductory accounting and finance manuals for
nonfinancial managers and advanced texts in corporate finance.
Finance for Executives is based on modern finance principles. It emphasizes rigor-
ous analysis but avoids formulas that have no direct application to decision making.
Whenever a formula is used in the text, the logic behind it is explained and numeri-
cal examples are provided. Mathematical derivations of the formulas are given in
the appendices that follow the chapter in which they first appear. Recognizing that
executives often approach financial problems from a financial accounting perspec-
tive, we begin with a solid review of the financial accounting system. We then show
how this framework can be extended and used to make sound financial decisions
that enhance the firm’s value.
• The chapters are self-contained.
Each chapter can be read without prior reading of the others. When knowledge of a
previous chapter would enhance comprehension of a specific section, we direct the
xxiii
xxiv Finance For Executives
reader to that previously-developed material. Further advice on this score is pro-

vided in the section titled “How to Read This Book.”
• The book can be read in its entirety or used as a reference.
The book can be used as a quick reference whenever readers need to brush up on a
specific topic or close a gap in their financial management knowledge. A comprehen-
sive glossary and the index at the end of the book help the reader determine which
chapters deal with the desired issue or topic. Most financial terms are explained
when first introduced in the text; they appear in boldface type and are defined in the
glossary.
• Data from the same companies are used throughout the book to illustrate
diagnostic techniques and valuation methods.
We focus on the same set of firms to illustrate most of the topics covered in this
book. This approach provides a common thread that reinforces understanding.
• Spreadsheet solutions and formulas are included in the text.
Recognizing that spreadsheets have become part of most executives’ tool kit, the text
shows the spreadsheet solutions to all the examples, cases, and self-test questions,
when applicable. Formulas used in the spreadsheets are shown at the bottom of the
tables for an immediate understanding of the solutions and for reproduction of the
spreadsheets for personal use.
• Each chapter is followed by self-test and review questions.
The self-test questions that appear at the end of each chapter allow the readers to
assess their knowledge of the subject. Most of the questions require the use of a
financial calculator or a spreadsheet. Detailed, step-by-step solutions to the self-test
questions can be found at the end of the book.
The review questions, which follow the self-test questions at the end of each
chapter, provide the readers with the opportunity to challenge their knowledge of
the subject and give the instructors relevant material to test the student’s grasp of the
concepts and techniques presented in the chapter. Solutions to review questions are
available online only to instructors.
MAJOR CHANGES IN THE SIXTH EDITION

As was the case with the previous editions of Finance for Executives, we have
incorporated in the sixth edition recommendations received from our colleagues at
INSEAD and other schools and from a large number of students and executives who
have attended courses and seminars in which the book was assigned. Here are the
major changes from the last edition:
• We have written an entirely new chapter (Chapter 16) entitled Understand-
ing Forward, Futures, and Options and Their Contribution to Corporate
Finance.
• We have moved the presentation on currency risk from Chapter 15 (Managing
Corporate Risk) to Chapter 17 (Making International Business Decisions).
• We use a new set of international companies from the pharmaceutical industry,
GlaxoSmithKline and Sanofi, to illustrate how to perform a financial analysis
using the concepts and techniques presented in Chapters 4 through 6.
Preface xxv
• We have updated all chapters with the latest available financial information.
• We have introduced spreadsheets throughout the chapters to illustrate the
valuation of bonds, stocks, and companies.
• We have prepared a new set of professionally designed PowerPoint slides to
accompany the book.
WHAT IS IN THIS BOOK?

Although the book consists of self-contained chapters, those chapters follow a logical
sequence built around the idea of value creation. The overall structure of the book
is summarized in a diagram on the following page that illustrates the value-based
business model. Managers must raise cash (the right side) to finance investments (the
left side) that are expected to increase the firm’s value and the wealth of its owners.
Part I, Financial Concepts and Techniques, begins with a chapter that surveys the
principles and tools executives need to know to manage for value creation. Chapter
2 presents the concept of time value of money and reviews the mechanics of calculat-
ing present values for different streams of cash flows. Chapter 3 explains the rela-
tionship between the risk of a financial asset and its expected return, and examines
the implications for financial investment management and the valuation of financial
assets.
Part II, Assessing Business Performance, reviews the techniques that executives
should use to assess a firm’s financial health, evaluate and plan its future develop-
ment, and make decisions that enhance its chances of survival and success. The chap-
ters in this part examine in detail a number of financial diagnostics and managerial
tools that were introduced in Chapter 1. Chapter 4 explains and illustrates how
balance sheets, income statements, and statements of cash flows are constructed
and interpreted. As an application, the appendix includes the financial statements
of GlaxoSmithKline, an international pharmaceutical company. Chapter 5 shows
how to evaluate a firm’s operational efficiency and its liquidity position. Chapter 6
identifies the factors that drive a firm’s profitability, analyzes the extent of its expo-
sure to business and financial risks, and evaluates its capacity to finance its activi-
ties and achieve sustainable growth. The financial analysis tools presented in these
chapters are applied to GlaxoSmithKline, whose financial statements are presented
in Chapter 4. The analyses appear in the appendices to Chapters 5 and 6, including a
comparative analysis of GlaxoSmithKline and one of its major competitors, Sanofi.
Part III, Making Investment Decisions, demonstrates how managers should make
investment decisions that maximize the firm’s value. Chapter 7 examines the net
present value (NPV) rule in detail and shows how to apply this rule to make value-
creating investment decisions. Chapter 8 reviews a number of alternative approaches
to the NPV rule, including the internal rate of return (IRR) and the payback period
rules, and compares them with the NPV rule. Chapter 9 shows how to identify and
estimate the cash flows generated by an investment proposal and assess the pro-
posal’s capacity to create value.
Part IV, Making Financing Decisions, explains how managers should make financ-
ing decisions that maximize value. Chapter 10 shows how to value bonds and common
stocks. Chapter 11 explains how firms raise fresh capital from financial markets policy
and share buybacks. Chapter 12 shows how to estimate the cost of capital for a particu-
xxvi Finance For Executives
PART I: FINANCIAL CONCEPTS AND TECHNIQUES
How to convert a stream of future cash flows into

their present value.
What is the relationship between the risk of a

financial asset and its expected return, and what are
the implications for financial and investment management
and the valuation of financial assets?
PART II: ASSESSING BUSINESS

PERFORMANCE
How to interpret financial information to assess PART IV: MAKING

performance (Chapter 4), and how do financial FINANCING DECISIONS
structure and operational efficiency affect a firm's
liquidity (Chapter 5), profitability, risk, and capacity
to grow (Chapter 6)? How to value the
securities that firms
issue to raise funds?
PART Ill: MAKING
INVESTMENT DECISIONS How do firms raise the
funds needed to finance
their investments and return
cash to shareholders?
2
the funds the firm raises?

3
PART V: MAKING BUSINESS DECISIONS
How to use forward, futures and option contracts to control risk.

7
How do international activities affect the firm’s value?
8
Is the firm using its resources efficiently to create value?
Preface xxvii
lar project as well as an entire firm. Chapter 13 explains how a firm should make value-
creating financing decisions by designing a capital structure (the mix of owners’ funds
and borrowed funds) that maximizes its market value and minimizes its cost of capital.
Part V, Making Business Decisions, concludes with five chapters on making
value-creating business decisions. Chapter 14 reviews various models and tech-
niques used to value firms in the context of an acquisition. Chapter 15 provides a
comprehensive framework to identify, measure, and manage the risks a firm faces.
Chapter 16 shows how forward, futures, and option contracts can be used to control
risk. Chapter 17 looks at financial management and value creation in an interna-
tional environment where currency and country risks must be taken into account.
Chapter 18 summarizes the analytical framework underlying the process of value
creation and examines some of the related empirical evidence.
HOW TO USE THIS BOOK

Depending on your background and your needs, you may want to use this book in
different ways. Below are a few guidelines. Also, refer to the exhibit on the next page
for suggested sequences of chapters to cover depending on the type of program taken.
• If you are unfamiliar with financial management and financial accounting,
you may want to begin by reading Chapter 1. It provides an overview of
these subjects and will help you understand the fundamental objective of
modern corporate finance and the logical relationships among the various
issues and topics that make up that field. Although reading the first chapter
will facilitate the understanding of those that follow it, it is not necessary to
read it to comprehend the rest of the book – the chapters are self-contained.
• If you are not familiar with the basic concept of discounting and the calcula-
tion of present values, you should read Chapter 2. The chapter also shows
you how to perform present value calculations with a financial calculator
and spreadsheets. If you skip Chapter 2, you will find a review of these
concepts in Chapter 7.
• If you wish to familiarize yourself with the concept of portfolio diversifi-
cation and financial investment management you should read Chapter 3,
but you do not need to read that chapter to understand any of the other
chapters in the book.
• If you are not familiar with financial statements, it would be helpful, but
not essential, to read Chapter 4 before you continue with the chapters
in Part II. The chapter explains how to read a balance sheet, an income
statement, and a statement of cash flows, and how to restructure these
statements to interpret the information they provide.
• If you are unfamiliar with the functioning of financial markets, you should
read the first five sections of Chapter 11 before you continue with the rest
of Part IV. These sections provide an overview of the structure, organiza-
tion, and role of financial markets.
• Last, if you have a basic knowledge of accounting and finance, you can go
directly to the chapter dealing with the issue you wish to explore. Because
the chapters are self-contained, you will not have to review the preceding
chapters to fully understand your chosen chapter.
xxviii Finance For Executives
Recommended Chapters According to Type of Program

Executive Education MBA Program
Chapter/Topic
1st course 2nd course 1st course 2nd course
1. Overview ü ü
2. The time value of money ü ü
3. Risk, return, and portfolio analysis ü
4. Financial statements analysis ü ü
5. Operational efficiency and liquidity management ü ü
6. Profitability and risk management ü ü
7. Capital budgeting: NPV ü ü
8. Capital budgeting: IRR & other methods ü ü
9. Capital budgeting: Cash flow analysis ü ü
10. Bond valuation ü ü
10. Common stock valuation ü ü
11. Financial markets and raising capital ü ü
11. Dividend policy and share buybacks ü ü
12. Estimation of the cost of capital ü ü
13. Designing a capital structure ü ü
14. Valuing and acquiring a business ü ü
15. Corporate risk management ü ü
16. Forward, futures, and option contracts ü ü
17. International capital budgeting ü ü
18. Managing for value creation ü ü
About the authors
Gabriel Hawawini (Ph.D., New York University) is

emeritus professor of finance at INSEAD where he
served as dean and held the Henry Grunfeld Chair
in Investment Banking. He taught finance at New
York University, Baruch College, Columbia Univer-
sity, and the Wharton School of the University of
Pennsylvania where he received the Helen Kardon
Moss Anvil Award for Excellence in Teaching.
Professor Hawawini is the author of 12 books
and more than 70 research papers on financial
markets and corporate finance. He teaches value-
based management seminars around the world and
sits on the board of several companies.
Claude Viallet (Ph.D., Northwestern University)

was emeritus professor of finance at INSEAD. He
was visiting professor of finance at Kellogg School
of Management, Northwestern University. Before
joining INSEAD, he worked as a project manager
at a major oil company and as chief financial offi-
cer of a service company in Paris.
Professor Viallet was president of the European
Finance Association and published widely in lead-
ing academic and professional journals. He also
organized, directed, and taught management-
development programs in Europe, the United
States, Asia, and Latin America and provided con-
sulting services to companies around the world.
xxix
Acknowledgments
A number of colleagues and friends have been most generous with the time they
spent reading parts of the manuscript for the previous editions and providing spe-
cific comments and suggestions. We also have received many useful comments from
students and executives to whom the book was assigned.
We want to thank in particular our colleague Professor Pierre Michel who
reviewed the first draft of many chapters, and made numerous insightful comments.
We also want to thank Dr. Chittima Silberzahn for helping us update some of the
exhibits, and Mr. Bennett Stewart of ISS Corporate Solutions who kindly provided
us with the data in Chapter 18.
Below is the list of individuals who made comments and suggestions to some of
the chapters in the current and previous editions of the book. We thank them all for
their feedback.
José Benzinho (ISCAC Coimvria Business Sergei Glebkin (INSEAD)

School, Portugal) Adam Golinski, (University of York)
Tomasz S. Berent (Capital Markets Department, Dwight Grant (University of New Mexico)
Warsaw School of Economics, Poland) Denis Gromb (HEC Paris, France)
Hugh-Joel Bessis (HEC Paris, France) George Hachey (Bentley College)
Soren Bjerre-Nielsen (Chairman of MT Alfred Hawawini (Mirakl)
Hojgaard, Denmark) Pekka Hietala (INSEAD)
John Boquist (Indiana University) Pierre Hillion (INSEAD)
David Borst (Concordia University) A. Can Inci (Bryant University)
Jay T. Brandi (University of Louisville) Laurent Jacque (Tufts University)
Dave Brunn (Carthage College) Donald Keim (The Wharton School)
Adrian Buss (INSEAD) Paul Kleindorfer (deceased) (The Wharton
Bruno Chaintron (INSEAD) School)
David Champion (Harvard Business Review) Pascal Maenhout (INSEAD)
Sudip Datta (Wayne State University) Sophie Manigart (Vlerick Business School,
Jean Dermine (INSEAD) Belgium)
Helene Dore (Crédit Agricole-CIB) Kenneth J. Martin (New Mexico State University)
Stephen Doukas (Montreat College) Pedro Verga Matos (ISEG School of Econom-
Bernard Dumas (INSEAD) ics and Management, Technical University of
Theodoros Evgeniou (INSEAD) Lisbon, Portugal)
Paolo Fulghieri (University of North Carolina) Roger Mesznik (Columbia University)
Marco Garro (Bocconi University, Italy) Pierre Michel (University of Liège and the Free
Federico Gavazzoni (INSEAD) University of Brussels)
xxx
Acknowledgments xxxi
Arjen Mulder (Department of Finance, Rotter- K. P. Sridharan (Delta State University)

dam School of Management, Erasmus University, Sascha Steffen (European School of Management
The Netherlands) and Technology, Germany)
John Muth (Regis University) Aris Stouraitis (City University of Hong Kong)
Robert Obermaier (Faculty of Business Admin- John Strong (College of William & Mary)
istration and Economics, University of Passau, Matti Suominen (Aalto University School of
Germany) Economics)
Jerome Osreryoung (Florida State University) Lucie Tepla (INSEAD)
Joel Peress (INSEAD) Andy Terry (University of Arkansas at Little
Urs Peyer (INSEAD) Rock)
Art Raviv (Northwestern University) Nikhil P. Varaiya (San Diego State University)
Lee Remmers (INSEAD) Maria Vassalou (Columbia University)
Maryanne Rouse (University of South Florida) Theo Vermaelen (INSEAD)
Niels Sandalgaard (Department of Business and Ingo Walter (New York University)
Management, Aalborg University, Denmark) Clement Wong (University of Hong Kong)
José Miguel Pinto dos Santos (AESE Business David Young (INSEAD)
School) A. Burcin Yurtoglu (Corporate Finance,
Antonio Sanvicente (IBEC Sao Paulo) WHU – Otto Beisheim School of Management,
Ravi Shukla (Syracuse University) Germany)
Finally, we thank all the staff at Cengage Learning for their help
and support in all the phases of development and production.
Gabriel Hawawini
Claude Viallet
January 2019
xxxi
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be unstoppable
Financial Management
and Value Creation:
CHAPTER
1
An Overview
An executive cannot be an effective manager without a clear understanding of the

principles and practices of modern finance. The good news is that these principles
and practices can be communicated simply, without sacrificing thoroughness or
rigor. Indeed, you will discover that most of the concepts and methods underlying
modern corporate finance are based on business common sense. But translating busi-
ness common sense into an effective management system can be a real challenge.
It requires, in addition to a solid understanding of fundamental principles, the deter-
mination and the discipline to manage a business according to the precepts of modern
finance. Consider, for example, one of financial management’s most useful guiding
principles:
Managers should manage their firm’s resources with the objective of increasing the
firm’s value.
This may seem to be an obvious statement. But you probably know a number of
companies that are not managed to their full potential value. You may even know
well-intentioned managers who are value destroyers. Their misguided actions, or lack
of actions, actually reduce the value of their firms.
How do you manage for value creation? This book should help you find the
answer. Our main objective is to present and explain the methods and tools that will
help you determine whether the firm’s current investments are creating value and, if
they are not, what remedial actions should be taken to improve operations. We also
show you how to determine whether a business proposal – such as the decision to
buy a piece of equipment, launch a new product, acquire another firm, or restruc-
ture existing operations – has the potential to raise the firm’s value. Finally, we show
you that managing with the goal of raising the firm’s value provides the basis for
an integrated financial management system that helps you not only evaluate actual
business performance and make sound business decisions, but also design effective
management compensation packages – compensation packages that align the interests
of the firm’s managers with those of the firm’s owners.
This introductory chapter reviews some of the most challenging issues and ques-
tions raised by modern corporate finance and gives a general but comprehensive
1
2 Finance For Executives
overview. Although the topics surveyed here are examined later in detail, many of
the important terms and concepts are introduced and defined in this introduction
with a clear indication of the relevant chapters you need to consult to get a complete
presentation of each topic. After reading this chapter, you should have a broad and
clear understanding of the following:
• The meaning of managing a business for value creation
• How to measure the value that may be created by a business proposal, such
as an investment project, a change in the firm’s financial structure, a business
acquisition, or the decision to invest in a foreign country
• The significance of the firm’s cost of capital and how it is measured
• Why some firms pay out cash dividends to their shareholders and buy back
their own shares in the open market
• The function of financial markets as a source of corporate funds and the role
they play in the value-creation process
• A firm’s business cycle and how it determines the firm’s capacity to grow
• The basic structure and the logic behind a firm’s balance sheet, income state-
ment, and cash-flow statement
• What is risk and how to define it, and how it affects the firm’s cost of capital
• How to measure a firm’s profitability
• How to determine if a firm is creating value
THE KEY QUESTION: WILL YOUR DECISION CREATE VALUE?

Suppose you have identified a need in the marketplace for a new product. You believe
the product can be manufactured cheaply and rapidly. You are even confident it can
be sold for a tidy profit. Should you go ahead? Before you make this decision, you
should check the project’s long-term financial viability. How will your firm finance
the project? Where will the money come from? Will the project be sufficiently profit-
able to cover the cost of the funds required to finance it? More to the point, will the
firm be more valuable with the project than without it? You should answer these
questions before making a final decision.
The proposed venture will be financed by the firm’s owners, its shareholders
(you may be one of them), and by those who lend money to the firm, the debt holders
(a bank, for example). Cash contributed by shareholders is called equity capital;
cash contributed by lenders is debt capital. As with any other resource, capital is not
free. It has a cost. Let’s assume that the firm’s annual cost of capital is 12 percent
of the total amount of capital employed, the sum of equity and debt capital. The
firm’s owners will find the venture attractive only if its operating profitability exceeds
12 percent, that is, only if its profitability before financing the venture is higher than the
cost of capital of 12 percent. Why? Because a project whose operating profitability
exceeds its cost of capital should generate more cash than is required to pay for the
cost of capital. It is that excess cash that makes the firm more valuable. (We will
explain this in more detail throughout the book.) In other words, before deciding to
go ahead with a business proposal, you should ask yourself the Key Question:
Will the proposal create value?
If, in light of existing information and proper analysis, you can confidently answer
“yes”, then go ahead with the project. Otherwise, you should abandon it.
Chapter 1 Financial Management and Value Creation: An Overview 3
The Key Question applies not only to a business proposal but also to current
operations. If some existing assets are destroying rather than creating value, you
should take immediate corrective actions. If these actions fail to improve perfor-
mance, you should seriously consider selling those assets.
The Importance of Managing for Value Creation

We realize, of course, that the Key Question is much easier asked than answered. The
next section describes how to apply the fundamental finance principle to help you
answer the Key Question. Before introducing that principle, we want to explain why
management’s paramount objective should be the creation of value for the firm’s
owners. This objective makes business common sense if you think about a firm whose
recent management decisions reduced the firm’s value. What would happen in this
case? The firm may be unable to attract the equity capital it needs to fund its activi-
ties. And without equity capital, no firm can survive.
You may rightly ask whether we are forgetting the contributions of employees,
customers and suppliers. No firm can succeed without them. Great companies have
not only satisfied owners, but also loyal customers, motivated employees, and reli-
able suppliers. The point, of course, is not to neglect customers, squeeze suppliers,
or ignore the interest of employees for the benefit of owners: more value for share-
holders does not mean less value for employees, customers, or suppliers. On the con-
trary, firms managed with a focus on creating value for their owners are among those
that have built durable and valuable relationships with their customers, employees,
and suppliers. They know that dealing successfully with employees, customers, and
suppliers is an important element in achieving their ultimate objective of creating
value for their owners.
Indeed, evidence supports the fact that firms that take care of their customers and
employees also deliver value to their owners. Consider the results of an annual survey
that asked executives, outside directors, and financial analysts to rate the ten largest
companies in their industry according to the following criteria: (1) quality of manage-
ment; (2) quality of products or services; (3) ability to attract, develop, and keep tal-
ented people; (4) company’s value as a long-term investment; (5) use of corporate assets;
(6) financial soundness; (7) capacity to innovate; and (8) community and environmental
responsibilities.1 The companies with the highest scores across all industries signifi-
cantly outperformed the Standard & Poor’s market index (an average of 500 c ompanies)
during the ten-year period that preceded the ranking. What was the stock market
performance of the companies with the lowest scores? They were value destroyers. They
delivered a negative return to their shareholders during the ten-year period that
preceded the ranking. An analysis based on only the three criteria that relate to the way
companies treat their customers (the second criterion), their employees (the third
criterion), and their community (the last criterion) showed similar results.2
These results clearly indicate that the ability of firms to create value for their
shareholders is related to the way they treat their customers, employees, and com-
munity. But you should not conclude that the guaranteed recipe for value creation
consists of delighting customers, establishing durable relations with suppliers, and
motivating employees. Some firms that deal successfully with their customers,
employees, and suppliers are unable to translate this goodwill into a higher firm value.
1
See fortune.com/worlds-most-admired-companies.
2
See Edmans (2011) and (2012). For international evidence, see Edmans, Li, and Zhang (2014).
What should the firm’s managers do in this case? They must revise the firm’s current
business strategy because their shareholders will eventually question the relevance of
a strategy that does not allow the firm to produce a satisfactory return on the equity
capital they have invested in it. Dissatisfied shareholders, particularly those holding
a significant portion of the firm’s equity capital, may try to force the firm’s manage-
ment to change course or may try to oust the existing management team. Or, they
may simply withdraw their support by selling their holdings to others who might
force changes.
Whether shareholders will be successful in getting management to change its
strategy, or even be replaced, depends on a number of factors, including the institu-
tional and legal frameworks that govern the relationship between management and
shareholders, and the structure and organization of the country’s equity markets in
which the firm’s shares are listed and traded. We simply suggest that no firm can
afford to have delighted customers, motivated employees, and devoted suppliers for
too long if it does not also have satisfied shareholders.
When asked in whose interest corporations are run, Mr. Jack Welch, the former
chief executive officer of General Electric, replied, “A proper balance between share-
holders, employees, and communities is what we all try to achieve. But it is a tough
balancing act because, in the end, if you don’t satisfy shareholders, you don’t have
the flexibility to do the things you have to do to take care of employees or communi-
ties. In our society, whether we like it or not, we have to satisfy shareholders.”3
The Saturn Story

In the early 1980s, General Motors (GM), then the world’s largest vehicle manufac-
turer, faced strong competition from foreign producers of small, efficient, reliable,
and inexpensive cars. In response to this challenge, in 1985, GM set up a separate
company to build an entirely new car, the Saturn. The car was designed, produced,
and sold according to the best practices available at the time. Workers were highly
motivated, car dealers could not keep up with demand, and customers were extremely
satisfied with their cars. According to these criteria, Saturn was an undeniable suc-
cess story.
The first car rolled off the assembly line in 1990. The project, however, never
delivered the rise in the value of GM’s shares that management had hoped would
occur.4 Why?
According to knowledgeable consultants, the $6 billion spent developing, manu-
facturing, and marketing the Saturn line of models was already so high that for GM
to earn an acceptable return for its shareholders it would have had “to operate
existing facilities at full capacity forever, earn more than double standard profit mar-
gins, and keep 40 percent of the dealers’ sticker price as net cash flow.”5
In 2009 GM stopped producing its line of Saturn cars, and in 2010 it discon-
tinued the Saturn brand after acknowledging that it had lost about $20 billion on the
project.6
3
Fortune, May 29, 1995, p. 75.
4
Fortune, December 13, 2004, “GM’s Saturn Problem,” pp. 119–127.
5
McTaggart, Kontes, and Mankins (1994), p. 16.
6
See the New York Times, October 1, 2009, “GM to Close Saturn After Deal Fails,” and “Saturn Corpora-
tion” in Wikipedia.org.
Our question is: how long should a firm fund a project that delights its customers,
pleases its distributors, and satisfies its employees, but fails to deliver value to its
shareholders? Obviously, not very long if it wishes to survive. So what can we con-
clude about the ultimate purpose of a business enterprise? Is it exclusively about
shareholder wealth creation, or is it about a “stakeholders’ approach” that tries to
balance the interests of all the parties associated with the firm (its customers,
employees, suppliers, and owners)? We believe that this is a false debate. The focus
should be on making decisions that raise the value of the firm, and in doing so, the
firm ultimately creates value for its stakeholders and society as a whole.7
THE FUNDAMENTAL FINANCE PRINCIPLE

Recall the Key Question you should ask before making a business decision: will the
decision create value? The Key Question can be answered with the help of the fun-
damental finance principle:
A business proposal – such as a new investment, the acquisition of another company,
or a restructuring plan – will create value only if the present value of the future
stream of net cash benefits the proposal is expected to generate exceeds the initial
cash outlay required to carry out the proposal.
The present value of the future stream of expected net cash benefits is the amount
of dollars that makes the firm’s owners indifferent to whether they receive that sum
today or get the expected future cash-flow stream. For example, if the firm’s owners
are indifferent to whether they receive a cash dividend of $100,000 today or get an
expected cash dividend of $110,000 next year, then $100,000 is the present value
of $110,000 expected next year. (See Chapter 2 for a review of how present values
are calculated.)
Measuring Value Creation with Net Present Value

The difference between a proposal’s present value and the initial cash outlay required
to implement the proposal is the proposal’s net present value or NPV:
Net present value 5 2Initial cash outlay 1 Present value of future net cash benefits
For example, if a firm’s owners are indifferent between $100,000 today and $110,000
in one year, then a project that requires $105,000 today to buy a machine that is
expected to generate a net cash flow of $110,000 next year, has a negative NPV of
$5,000 because next year’s cash flow is worth $100,000 today, which is $5,000 less
than the initial cash outlay:
NPV 5 2$105,000 1 $100,000 5 2$5,000
If the project is undertaken, it would reduce the value of the firm by $5,000.
We can use the NPV concept to restate the fundamental finance principle more
succinctly:
A business proposal creates value if its NPV is positive and destroys value if its NPV
is negative.
7
For a discussion on whether creating value for owners also creates value for all the firm’s stakeholders,
see John Martin, William Petty, and James Wallace (2009).
The proposal’s NPV goes to the investors who own the project – in other words, to
the shareholders of the firm that undertakes the project. This means that the share-
holders should be able to sell their equity stake in the company that announced the
project for more than they could sell it for if the project were not undertaken, and
the difference should be equal to the project’s NPV.
The firm’s ability to identify the project, and the market expectation that the
firm will carry out the project successfully, create an immediate increase in the firm’s
value and in the wealth of its owners. More precisely, if the shares of the firm are
listed and traded on a stock exchange, the market value of the firm (the share price
multiplied by the number of shares outstanding) should rise by an amount equal to
the project’s NPV on the day the project is announced, assuming the announcement
is unanticipated, and the market agrees with the firm’s analysis of the project’s profit-
ability. We return to this point later in the chapter when we examine the role played
by financial markets in the process of value creation.
Only Cash Matters

The fundamental finance principle requires that the initial investment needed to
undertake a proposal, as well as the stream of net future benefits it is expected
to generate, be measured in cash. As Exhibit 1.1 shows, the investors who are
financing the proposal – the firm’s shareholders and debt holders – have invested
cash in the firm and thus are interested only in cash returns. Note that the cash
benefits of a project must not be confused with the increase in the firm’s net profit
expected from the project because profits are accounting measures of benefits, not
of cash returns.
Chapter 4 identifies the differences between a firm’s cash flows, its revenues, its
expenses, and its net profit, and Chapter 9 shows how to estimate the cash flows that
are relevant to an investment decision.
Discount Rates
Consider an investment proposal that requires shareholders to invest $100,000 today
in order to generate an expected $110,000 of cash at the end of the year. Suppose
that the present value of the $110,000 is $100,000. Recall that the present value is
the value that makes the firm’s owners indifferent to whether they receive $100,000
Exhibit 1.1 Only Cash M atters to Investors.
today or receive the expected $110,000 in one year. This is the same as saying that
the firm’s owners expect to receive a return of 10 percent from the project because
$100,000 invested at 10 percent will yield $110,000 in one year. The 10 percent is
called the discount rate: it is the rate at which the future cash flow must be dis-
counted to find its present value. In other words, $100,000 is the discounted value
at 10 percent of $110,000 to be received in one year.
If we want to estimate the NPV of a proposal, we must first discount its future
cash-flow stream to find its present value and then deduct from that present value
the initial cash outlay required to carry out the proposal. Chapter 2 examines the
discounting mechanism in detail and explains how to calculate present values and
how to estimate a project’s NPV when the project has an expected cash-flow stream
that is longer than one year.
In our example, we know the discount rate (10 percent) because we already know
the expected future cash flow ($110,000) and its present value ($100,000). However,
this is not usually the case. In general, a proposal’s future cash flow must be estimated,
and the discount rate must be determined. But what discount rate should be used?
A proposal’s appropriate discount rate is the cost of financing the proposal.
In the example, the return expected from the project must be at least 10 percent
to induce shareholders to invest in the project. In other words, because 10 percent is
the rate of return required by shareholders to fund the project, it is also the project’s
cost of equity capital. It represents the cost of using shareholders’ cash to finance
the investment proposal.
A Proposal’s Cost of Capital

In the previous example, the project was funded only with equity capital. Firms,
however, typically finance their investment proposals with a combination of equity
capital and debt capital, and both shareholders and debt holders require a return
from their contribution to the financing of the proposal. When a project is funded
with both equity and debt capital, the cost of capital is no longer equal to just the
cost of equity. It is the weighted average of the project’s cost of equity and its after-
tax cost of debt,8 where the weights are the proportions of equity and debt financing
in the total capital used to fund the project.
To illustrate, suppose a project will be financed 50 percent with equity and
50 percent with debt. Also, assume the project has an estimated after-tax cost of
debt of 4 percent and a cost of equity of 12 percent. Then, the project’s weighted
average cost of capital or WACC is equal to 8 percent:
Project cost of capital 1 WACC 2 5 1 4% 3 50% 2 1 1 12% 3 50% 2

5 2% 1 6%
5 8%
In other words, the contribution of debt financing to the project’s cost of capital
is 2 percent (50 percent of 4 percent) and that of equity financing is 6 percent
(50 percent of 12 percent) as shown in Exhibit 1.2.
If the proportions of equity and debt financing are modified, the WACC will be
affected, not only because the financing proportions have changed but also because
the cost of debt and the cost of equity change when the financing proportions are
8
We explain in Chapter 12 why the cost of debt must be taken after tax.
The Cost of Financing a Business Proposal is its Weighted Average

Exhibit 1.2
Cost of Capital.
altered. Chapter 12 shows how to estimate a project’s cost of debt as well as its cost
of equity and WACC. Chapter 13 demonstrates how the WACC is affected when the
financing proportions change.
APPLYING THE FUNDAMENTAL FINANCE PRINCIPLE

The fundamental finance principle has widespread applications in major areas of corpo-
rate decision-making. In this book, we address the capital budgeting decision (whether
an investment project should be accepted or rejected), the payout policy (when and how
much cash the firm should distribute to its shareholders through cash dividends and/or
by buying back its own shares in the open market), the capital structure decision (how
much of the firm’s assets should be financed with equity and how much with debt), the
business acquisition decision (how much should be paid to acquire another company),
and the foreign investment decision (how to account for multiple-currency cash flows
and for the different risks of operating in a foreign country). The capital budgeting
decision is covered in Chapters 7 through 9, the payout policy in Chapter 11, the
capital structure decision in Chapter 13, the acquisition decision in Chapter 14, and
the management of cross-border operations in Chapter 17. This section provides an
overview of these corporate decisions.
The Capital Budgeting Decision

The capital budgeting decision, also called the capital expenditure decision, is
primarily concerned with the acquisition of fixed assets, such as plant and equipment.
This is a major corporate decision because it typically affects the firm’s business per-
formance for a long period of time. The decision criteria used in capital budgeting,
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nerve the head and strengthen the arm, so as to give the needed
daring and power. If you could annihilate liquors, it seems to me that
you would annihilate the whole profession of thieves, blacklegs,
burglars, robbers and counterfeiters. Get rid of those who sell
liquors, and you get rid of these felons; for they could not endure
such lives as they lead, unless braced up by the stimulus of strong
drink.
“Well—my story is now told. I have only to say, that I was taken at
last, for one of my crimes, tried, convicted, and sent to this place. But
I shall stay here a short time only. My health is gone—though scarce
eighteen years of age; my constitution is wasted away, and the lamp
of life is near going out forever!”
Here the poor youth sunk down upon his bed, completely
exhausted. He closed his eyes, and by the flickering light of a remote
lamp, his face seemed as pallid as marble. It looked like the very
image of death, and I felt a sort of awe creeping over me, as if a
corpse was at my side. At last I could hear him breathe, and then I
went to bed. I reflected long upon what had happened. “I have
thought,” said I, mentally, “that I was most unhappy, in being
destitute of the care and instruction of parents; but there is a poor
youth, who is still more wretched, and who yet has enjoyed the
blessing denied to me. The truth is, that after all, good or ill fortune,
is usually the result of our own conduct. Even if Providence grants us
blessings, we may neglect or abuse them; if they are denied to us,
we may, by a steady pursuit of the right path, still be successful in
gaining happiness.” With this reflection, I fell asleep; but when I
awoke in the morning, the young man at my side was sleeping in the
repose of death!
Sketches of the Manners, Customs, &c., of the
Indians of America.
chapter xxiii.
General resemblance.—Food.—Fishing.—Hunting.—Houses.—
Dress.—Manner in which they train their children.
A strong resemblance in personal traits exists throughout the

numberless native tribes of North America. They are generally tall,
straight, and robust. Their skin is of a copper-color; their eyes large,
bright, black, and piercing; their hair long, dark and coarse, seldom
or never curled; and to their simple diet and active life they owe their
white and regular teeth, and their excellent health.
Their food is such as they can obtain from the rivers and the
forests; hunting and fishing, and fighting form the chief pursuits of
the American savages. Before the arrival of the whites, very little
labor was expended in tilling the lands; and, even that little, was
done mostly by the women. But since their hunting-grounds have
become too small, and game too scarce to allow them to support life
in this way, they have begun to turn their attention to the riches
which labor and time can draw from the bosom of the fertile soil.
The natives made use of both spears and nets in their fisheries.
They had a way of fishing in the night time, by means of a fire
kindled on a hearth in the middle of their canoes, which dazzled the
fishes by its light, and enabled those in the boats to take them easily
with a spear. They sometimes built a fence or dam entirely across
the mouth of some small river, leaving only one opening, at which
they placed a sort of pot or box, made very much in the form of a
mouse-trap, into which the fish were carried by the stream, and thus
caught.
Before the Indians had learned from Europeans the use of fire-
arms, their only method of hunting was by means of bows and
arrows, and traps. In shooting with the bow, they were very expert,
but they have now generally laid it aside for the gun.
They had a very ingenious way of taking a great number of deer
and other large animals at a time. They first make two fences of
strong pointed stakes, so high that the deer cannot leap over them.
These fences at one end are very far apart, but they gradually
approach near each other, until there is but a small opening between
them, which leads into a small enclosure in the form of a triangle. At
the farther end of this triangle is a small covered way; large enough
to allow one deer to pass into it.
When all this is prepared, a great number of people assemble
together, and forming a half circle around the forest, advance slowly,
driving before them all the animals which it contains. These, finding
themselves hard-pressed, run on, until they come to the fences,
which they follow along, and thus enter the small enclosure to which
they lead. Here there is no returning, as the hunters block up the
narrow passage; the affrighted herd are compelled to enter the
covered way of stakes, where they are easily killed with a spear.
The morning is the best time for hunting. This the Indian knows
well, and he is always up and off in the woods before daylight, in
hopes to be able to return at breakfast time with a deer, turkey,
goose, or some other game, then in season. Meantime, his wife has
pounded his corn, now boiling on the fire, baked her bread, and
spread their mat in the open air, under the bright beams of the
morning sun. And when the hunter returns with his load of game,
they sit down to their simple meal, sweeter to them than the dainty
repast of a Roman emperor—for it has been purchased by the labor
of their own hands.
The houses of the Indians are built of a frame-work of small trees
or poles, with a covering of bark or branches of trees; a hole in the
top lets out the smoke, and a small opening in the side, with a mat
hung before it, serves for a door. These huts or wigwams are
generally small and dirty, and cannot be very agreeable residences;
but this is of little consequence, as the natives spend most of their
time in the open air. The tribes of Virginia lived in villages, which
were generally surrounded by rows of palisadoes, or strong
sharpened stakes, to secure them from the attacks of an enemy.
Formerly, the Indian dress consisted entirely of the skins of
different animals, which they could dress until they became quite soft
and pliant. Now, they generally make use of cloth, which they obtain
from their civilized neighbors. They wear a blanket or coat of skins
wrapt around the body, leggings, or close stockings, for the leg, and
moccasins, or shoes made of skin, for the feet. Of course, the
fashions vary in different countries; the Virginians were by no means
so well clad as the natives of Canada.
Like all other half-civilized nations, the natives of America delight
in ornamenting their persons. A young Indian warrior is, perhaps, as
thorough-going a beau as any in the world. Heckewelder tells us of a
young acquaintance of his, who had spent a whole day in preparing
himself for a dance. His face was painted in such a singular style
that it appeared different in every different view. When seen from the
front, his nose appeared very long and narrow, with a round knob at
the end, much like the upper part of a pair of tongs. When viewed in
profile, on one side his nose represented the beak of an eagle; on
the other side it resembled the snout of a pike, with the mouth open,
so that the teeth could be seen. On one cheek there was a round
spot of red, and on the other one of black; while the eyelids were so
colored that they appeared to be upside down. This was the Indian
ball dress; and the young dandy warrior was evidently very proud of
his work.
They paint themselves on various other occasions; they do it in
war, to strike terror into their enemies. The warriors of one tribe are
known to paint their bodies with white streaks on a black ground so
as to give them the hideous appearance of skeletons. In peace, the
paint is generally blue, or some other light color.
Most Indians are in the habit of changing their place of residence
several times a year, for the purpose of finding better hunting-
grounds, or of retreating from their enemies. In their journeys, as in
everything else, the women do all the drudgery of the household,
such as packing up, and carrying the movables, and raising again
their little cabin in their new situation. Such being the case, their
furniture must be scanty and light. The dry leaves of the forest, with
a blanket or a few skins, serve for a bed; a small iron kettle to boil
their food, a mortar to grind their corn, with a few gourds, and, mats,
make up the furnishing of an Indian wigwam.
To these, perhaps, should be added the cradle, which is as unlike
the cradle in which, when little children, we have been gently rocked
to sleep, as can be conceived. The cradle of the Indian babe is
nothing but a hard board, to which the helpless infant is bound with
strong bands or strips of wood, bent over like pieces of hoop. The
cradle with the child is then hung on the branch of a tree, where it
rocks to and fro in the wind, or is fastened to the back of its mother in
her travels; the little pappoose enduring, without a sign of pain or ill-
temper, all the hard knocks which it is obliged to receive in this
situation.
The Indians never punish their children; they say it breaks the
spirit of the young warriors, and that their sons will never be brave in
fight, unless they are bold and forward in their youth. The parents,
however, take another way to infuse into the minds of their children
good principles, and a respect for the aged. This they do by exciting
their pride and emulation; they tell them that if they follow the advice
of the most admired and extolled hunter, trapper, or warrior, they will,
at a future day, obtain a reputation equal to that which he possesses;
that, if they respect the aged and infirm, they will be treated in like
manner when their turn comes to feel the infirmities of old age.
These precepts seldom fail of effect; the ambition of the child is
aroused; and he listens to the directions of those older and wiser
than himself, in hopes of being, one day, admired and respected for
his own bravery and wisdom. But although this may stimulate the
faculties of youth, and may give them vigor, it is little likely to
cultivate self-restraint, and the habit of acting according to a rule of
duty.
When a boy becomes old enough to hunt, his father takes him out
into the woods, and teaches him how to proceed. The youth calls to
mind the lessons which he has received, in listening to the words of
the most famous hunters, and he resolves to equal them. The first
game which he kills, whatever it be, is immediately cooked, and all
the friends and relatives of the family are invited to the “boy’s feast.”
From that time, he takes his place among the men, and he is
expected to contribute, by his bow, his gun, or his net, to the support
of the family.
When a young man arrives at the proper age to marry, he begins
to look about him among the young women of his tribe, and if he
sees any with whose looks and behavior he is pleased, he
endeavors to gain her favor by presents and soft speeches. The
parents of the young people soon perceive the attachment, and a
negociation commences. The mother of the young man takes a
choice piece of meat and carries it to the house of the girl’s parents,
never forgetting to mention that her son was the successful hunter of
the game. The mother of the young woman, on her part, brings a
dish of victuals, such as beans, or Indian corn, to the wigwam of the
other, saying, “This is the produce of my daughter’s field.”
If the old ladies are able to tell the good news to each other that
the young people have pronounced the articles sent to them, “very
good,” the bargain is concluded. From that time, it is the duty of the
man to bring home game enough to support the family, while his wife
exerts herself to cook the victuals, prepare the clothes of her
husband, and till their little field of Indian corn, and other vegetables;
and though her labors are undoubtedly severe, yet she knows that
the time and abilities of her husband are taken up in the all-important
duties of hunting, fishing, and trapping, and she is never unwilling to
perform her part.
chapter xxiv.
Customs of the Indians in their intercourse with each other.—
Anecdote of the missionaries.—Usages in respect to murder—war
—peace—religion.—Traditions.—Superstitions.—Their ideas of
heaven.—General character, and probable fate.
Hitherto we have regarded the Indians in their private and

domestic relations. Let us now glance at them in their intercourse
with one another, their laws, and their conduct towards other nations,
both in war and in peace.
The natives are brought up with a high sense of their own dignity
and honor, and they are always certain to feel and avenge an affront.
Hence, in their ordinary conversation, they take great care not to
excite the passions of others. They sometimes carry this civility
almost too far; they will seldom dispute anything which another
asserts, and they require the same complaisance in return.
It is said that a missionary was once preaching to the Indians, and
explaining to them the divine truths of the gospel, while his tawny
auditors listened in assenting silence. When he had finished, a chief
arose and observed that all the white man had said was very good,
and might be followed; he then related the tradition of his nation
concerning the first production of certain plants. But when the
missionary expressed himself disgusted with the idle tale, the Indian,
offended, replied—“My brother, it seems your friends have not done
justice to your education; we are willing to believe all the stories
which you tell us, why do you not believe ours?”
If it should ever happen, however, that an Indian, in a fit of
passion, should kill another, it is the duty of the relations of the
murdered man to avenge his death. The murderer knows his fate,
and submits without a struggle. Sometimes it is the case that the
rank and power of the criminal is so great, that no one cares to
execute the fatal decree of vengeance; at other times he is adopted
by the family of the deceased in his place.
When the murder has been committed on a person of another
tribe, the consequence is generally war. This, like all other important
measures, is first determined upon by a grand council of chiefs and
warriors. In these assemblies, the greatest order and decorum
always prevail. The most aged and respectable always speak first,
and no one thinks of interrupting one who is speaking. Even after he
sits down, they are silent for a few minutes, in order that they may
seem to reflect upon what he has spoken.
If war is finally concluded upon, a large painted post is set up in
an enclosed place, and the warriors, begrimmed with paint and
holding their tomahawks in their hand, dance with frantic gestures
around it, singing their war-song. As many as join in the dance, are
bound to go out against the enemy; this is the Indian mode of
recruiting.
In their warfare, every species of cunning and cruelty is practised,
and all the ferocity of a savage nature breaks forth. When a town of
the enemy is attacked and taken, no age or condition is spared;
infants, old men, and women fall in indiscriminate massacre. Even
those that are spared, are reserved for a yet more terrible fate.
When a victorious expedition returns home, the scalps of their
slain enemies are carried in front, fixed on the end of a thin pole; the
prisoners follow, and then the warriors advance, shouting the
dreadful scalp-yell, once for every head which they have taken, dead
or alive.
When the captives enter the village, they are shown a painted
post at the distance of from twenty or forty yards, and told to run for
it. On each side of the way stand men, women, and children, with
axes, sticks, and other weapons, ready to strike him as he passes. If
he shows himself prompt, and bold, and makes, with all speed, for
the post, he is generally certain of reaching it without much harm;
and, in that case, he is safe, until his final destiny is determined
upon. This is called—running the gauntlet.
Sometimes he is adopted into the tribe, in place of others slain in
the war; or he is left to be ransomed by his friends. But if he be a
great warrior, who has done them much injury, he is generally
condemned to suffer by the fiery torture. He is stripped naked and
bound to a tree; a heap of dry brush is placed around him, and set
on fire, while his enemies dance in triumph around the victim,
exulting in his torment. He, on his part, meets his fate with firmness,
even in this horrid form; he sings his death-song, relates his exploits
against his enemies, and taunts them with cowardice, telling them
that they are no more than so many old women, and bidding them
look on and see how a man can die!
When a war is to be concluded, or, in the language of the Indians,
who are fond of metaphorical expressions, when the hatchet is to be
buried, and the path of peace to be opened to their enemies’ country,
messengers of peace are sent, carrying with them a calumet, or
pipe, with a long stem adorned with the feathers of the rarest birds.
This pipe is lighted, and presented to the chiefs of the hostile tribe; if
they smoke it, it is a sign that the proposals are agreed to, and that
the hatchet is buried under the tree of peace. But if, on the other
hand, they refuse to receive it, the war is continued with as much
fury as ever.
There never was a nation without some religion. Even the most
barbarous and degraded African tribes have some divinity which
they worship. The natives of America believe in a Great Spirit, or
Manito, who created the world in the beginning, and governs all
things with absolute sway. Under him are many inferior spirits, some
good and others bad, who have each his particular duty to perform.
There is a god in the sun, another in the moon, and another for every
appearance which they do not understand. When the natives first
saw the white men of Europe, they took them to be Manitos, and
paid them the honors which they rendered to their god.
The Indians have all some dim tradition of the deluge; but farther
than this, their traditions do not extend. Some believe that a beaver,
who was swimming about upon the water, dived to the bottom, and
brought up a little earth in his paws, from which the land was formed.
Concerning the origin of the Indians themselves, they relate that for
a long time they lived under ground, in the shape of some other
animals, such as the bear, the beaver, and even the oyster, which, in
time, were changed to men.
After remaining a long time in this abode, some of their young
men who were out on a hunting expedition, discovered a hole in the
earth, through which they ascended and came to a fine country, well
stocked with game, fruit, and all other necessaries of life. They
returned to their people, told them of their wonderful discovery, and
all forthwith ascended and took up their residence on the earth. The
Mandans, however, say that some of their tribe yet remain under
ground; for a very fat woman, in her eagerness to reach the desired
land, laid hold of the vine by which they climb up, so roughly, that it
broke down, and those which were left, were forever prevented from
joining their companions.
The Indians of Virginia called their Great Spirit Quiouos. Some
gentlemen who were once ranging the woods near the settlements,
came upon the temple of this god, and took the liberty, as they saw
no one near, to open the door and go in. It was a cabin, somewhat
larger than usual, and at the farther end was a recess, before which
hung a curtain. On a shelf in this recess, they found some pieces of
wood and cloth, which, when put together, they found to be the
famous idol of the Virginians. As the cabin had no windows, this
figure, seen by the glimmering light from the door, must have
appeared to its benighted worshippers really terrific.
The Indians are a very superstitious race of people, and there are
always some who are willing to take advantage of the weakness of
their countrymen to serve their own interest. Such are the jugglers
and sorcerers—an artful and mischievous set of people. They
pretend to have power over the elements, to bring rain, to cure
sickness, to cause death, and to change themselves to any form, by
means of their charms and medicine.
Mr. Heckewelder was one day walking out, during a very severe
drought, and came upon an old conjurer, named Chenos, who was
engaged in some of his mummeries. The missionary asked him what
he was doing.
“Oh,” said he, “I am hired to do a very hard day’s work. I am going
to bring down rain from the sky; don’t you see how much it is
wanted, and that the corn and everything else is perishing?”
“But can you make it rain?” said Mr. Heckewelder.
“Certainly,” replied the old conjurer, “and you shall be convinced of
it this very day.”
He had, by this time, encompassed a square, of about five feet
each way, with stakes and pieces of bark, so that it might resemble a
pig-pen of about three feet in height, and now, with his face uplifted
and turned towards the north, he muttered some words, as if
invoking a superior being. He did the same on the south, and then
made a small opening in the side of the pen. “Now,” said he, “we
shall have rain enough.”
And he was right; a few hours afterwards, the sky suddenly
became overcast, and a plentiful shower of rain succeeded; proving
to every Indian’s mind, the power of their conjurer, and the efficacy of
his prayers. It is evident that the old Chenos had paid good attention
to the signs of the weather, and his experience enabled him to
foresee that there would soon be rain, without the aid of supernatural
powers.
The Indians put great faith in dreams; they believe that while the
body sleeps, the soul leaves it and acts for itself; and they think that
everything which they dream ought to be fulfilled when they awake.
A chief of the Mohawk tribe, Hendrick by name, resolved to turn
this belief to good account. On a visit to Sir William Johnson, the
superintendent of Indian affairs in America, he had been very much
struck with the brilliancy of his host’s suit of clothes, which were new
and were richly covered with gold lace. A few days afterwards, he
called on Sir William, and told him that he had dreamed a most
singular dream. The other inquired what it was.
“I dreamed,” answered Hendrick, “that you gave me the fine suit
which you wore the other day.”
Sir William took the hint, and gave him the clothes; but he
resolved to dream in his turn; accordingly, not long after, he went to
the wigwam of his red friend, and informed him that he had dreamed
that Hendrick made him a present of a very fine tract of land of about
five thousand acres.
“Have you really dreamed that?” inquired the chief, in dismay;
and, after a moment’s pause, “Very well,” said he, “you shall have
the land; but if you please, Sir William, we will not dream any more.”
The heaven of every nation is a place where the greatest degree
of happiness is to be enjoyed hereafter; and of course it differs
among different nations, according to their various notions of
happiness. The Indians placed their chief pleasure in a life of easy
indolence, varied only by the delights of hunting and gaming. Their
paradise is, therefore, a land of eternal spring, where the sun’s
beams are ever mild and refreshing, and where the green woods are
stocked with every animal suitable for eating and the chase; and the
waters are filled with fish of the most delightful flavor.
Not only the souls of men but also those of animals are admitted
into this happy abode. And hence, among some tribes, it is the
custom to shoot the dead man’s horse over the grave of his master.
But the way to this heaven is long and full of dangers; such as
meeting with ferocious wild beasts, crossing rapid streams on a
single log, and the like. To enable the warrior to pass safely through
all these and to gain his subsistence until he arrives at his future
abode, they place in his grave weapons for hunting, a pipe, a tinder-
box and flint, together with food, and in modern times a bottle of rum
is added, if the man has been in life, very fond of this destructive
liquor—a thing but too common among the natives.
Thus have we followed the Indian of North America from his birth
to the place where he awaits the joys of another life—from his “tree-
rocked cradle,” to his grave. Let us now glance at his general
character and his probable fate.
It must be owned that the character of the Indian of the north, is
by no means amiable. He is bold, but reserved, even to his friends;
fierce and implacable to his enemies; indolent, except when pressed
by hunger, or excited by revenge. Too proud to condescend to labor
with his own hands, he compels his wife to bear the drudgery of the
lodge, a sure sign of the savage. He never forgives an injury, never
forgets a kindness. In war he is brave and cunning, in religion
superstitious and cruel.
His virtues and his vices are all those of a barbarian; and such, it
is to be feared, he will ever be. The attempt to civilize the natives
within the limits of the United States, has been made often and
zealously for more than two hundred years, but in vain. The remnant
of this once powerful race is melting fast away, as one of their own
orators express it, “like snow before the sun;” and perhaps, in a
century more, not one will be left to remind us that the land which we
inhabit was once their own. Still, it is no less our duty to do all we
can to save and render happy, for a while, at least, the feeble
remnants of a people to whom we owe so much.
In the crowded saloon of Mr. Catlin, the Indian lecturer, in the

midst of an intensely interesting discourse, a person rose up, and in
a solemn manner said, “Mr. Catlin, will you have the goodness to
stop for a moment?” The audience looked with astonishment, and
the lecturer paused: “I have lost my little boy in the crowd,” said the
gentleman, “and wish to call for him.” A dead pause ensued in the
1200 persons present. “Clark Potter,” said the father. “Here I am,
father,” said a shrill voice in the corner; at which shouts of laughter
and applause ensued, and the stripling was handed over the
benches to his anxious parent.
An Irishman, wishing to dispose of his watch, said, by way of

recommendation, that it had beat the church clock that blessed day
by an hour and a half.
The Stock-Dove, &c.
There is a wild pigeon in Europe, called the Stock-Dove, from

which the various kinds of domestic doves are bred. In its native
state, this bird builds in rocks or decayed trees; its color is of a deep
bluish-ash color, the breast being dashed with a fine changeable
green and purple.
The varieties of the domestic pigeon are very great, and some of
them are very curious; yet, in their general habits, they are the same.
They breed every month; lay two eggs, and hatch two at a time. The
female sits from four in the afternoon till ten the next morning; the
male takes her place, from ten to four. In this manner they sit
alternately, till the young ones are hatched.
The affection of doves to each other is remarkable, and their
cooing notes are very soft and pleasing. The constancy of the
female, in sitting upon her eggs, is so great, that one bird was once
known to continue faithful to her task till the young were hatched,
though her legs in the mean time became frozen and dropped off!
So prolific are these birds, that fifteen thousand may be reared
from a single pair, in four years. Most birds drink by sipping at
intervals; pigeons drink at long draughts, like quadrupeds.
There is a kind of pigeon called carriers, and which are used to
carry letters from one place to another. These may be easily
distinguished from all others by their eyes, which are compassed
about by a broad circle of naked white skin, and by being of a dark
blue or blackish color. It is from their attachment to their native place,
and particularly where they have brought up their young, that these
birds have been employed in several countries as the most
expeditious travellers.
They are first brought from the place where they were bred, and
whither it is intended to send them back with information. The letter
is tied under the bird’s wing, and after feeding it well, lest it should
stop upon the way to eat, it is let loose to return. The little animal no
sooner finds itself at liberty than its passion for its native spot directs
all its motions.
It is seen upon these occasions flying directly to the clouds, to an
amazing height, and then with the greatest certainty and exactness,
directing itself by some surprising instinct, towards home, which lies
sometimes at many miles distance. It is said that in the space of an
hour and a half, they sometimes perform a journey of forty miles.
(As a great number of my readers have desired me to continue
the story of Philip Brusque and the island of Fredonia, I have
concluded to give the remainder of it.)
Story of Philip Brusque.
chapter xii.
It is natural for mankind to love power; a child loves it, and always
seeks to govern his parents and his playmates. Men seek also to
govern their fellowmen. This desire is stronger in some than in
others; there are persons who are always striving and contriving, for
the purpose of acquiring authority over those around them.
Now when several people unite for a certain object, we call them
a society; if they unite for religious purposes, we call them a religious
society; if for charity, we call them a charitable society; if for
government, we call them a political society, because politics is the
business of government.
Wherever there is society, we see this love of power; we there find
persons who are seeking, by all sorts of means, to acquire authority,
so that they may rule. We find it even in school—for there we meet
with girls and boys, who strive not only to sway the teacher, but the
other scholars; we find it in villages—for there we meet with men
who are plotting to gain an ascendency; in short, we find it
everywhere, in towns and cities, in states, countries, and kingdoms.
Now this love of power is a selfish thing, and though it may lead to
good, yet it is very apt to lead to evil. It is this which has caused
conquerors to murder millions of their fellow-men; it is this which has
led politicians to practise every sort of fraud and deception. And one
thing is to be remarked here, that when a person desires power, so
much as to take dishonest or trickish means to obtain it, he is not fit
to possess it. Such a person will only use it selfishly, and not for the
good of those who may come under his authority.
It was fortunate for the little society of Fredonia, that in choosing
Mr. Bonfils for a governor, they selected one who did not desire
power for any selfish reason, and who accepted the office bestowed
upon him only in the hope of benefiting the people. He felt like a
father to his children, and his thoughts were, therefore, bent upon
the means by which their happiness could be promoted. If he had
been a selfish person, he would have turned his mind to consider
how he might best promote his own ambition; how he might acquire
more power; and how he might secure and perpetuate his sway.
You have heard of Washington, who was president of the United
States: now he never strove to get that high office, and he only
accepted it, in the hope that his government might bless the nation.
You have heard of Bonaparte; he became the emperor of France;
but he did it by his own efforts. He did not wait to be chosen a ruler;
but he seized the reins of power. He commanded the people to make
a crown, and then he commanded them to put it on his head, and
call him emperor: and they obeyed. Having thus acquired vast
power, having command of the army and the navy; having all the
money of the government—he put them in requisition to carry on
wars of conquest. His love of power was so great that he was not
content with ruling over the thirty millions of people in France; he
yearned to reign over all Europe—over all the world. His ambition
was so boundless and grasping, that the nations of Europe rose
against him, hurled him from his throne, and caused him to be
confined to the rocky island of St. Helena, where he died.
Now Mr. Bonfils was like Washington, and not like Bonaparte. He
took the office of governor, only to do good to his people. His first
thought, upon becoming the ruler, was to discover what could be
done to make the little nation of Fredonia, peaceful and happy. In
looking around, he saw many things to give him anxiety. In the first
place, the clothes of the people were fast wearing out, and the tents
in which they lived, being covered with the sails of the ship, were
small and uncomfortable. They might do pretty well for the dry
season, but what was to be done when the autumn rains should set
in? And, in addition to all this, the people had only a very few articles
of furniture, and in this respect, they were exceedingly
uncomfortable.
While, therefore, clothes, dwellings, and furniture, were needed,
there was another still more pressing want, and this was food. The
flour, bread, and biscuit, brought from the ship, were entirely gone;
the meat was all devoured; the salt, pepper, and spices were entirely
used up. The island, as I have said, produced many fruits,
particularly oranges; it also yielded pine-apples, a few melons,
grapes, and pomegranates. Upon these fruits the people had now
subsisted for several weeks; but Mr. Bonfils saw, that long before
another season could return, the fruits of the island must be
exhausted, unless something could be done to furnish food from
other sources, and protect what there was from waste.
On making inquiries, he ascertained that there were no cows,
sheep, deer, or hogs upon the island; and, saving a few wild goats
that lived around the cliffs, there were no animals of considerable
size. There were a few monkeys, a considerable number of lemurs,
and a great variety of macaws, paroquets, and other birds of gay
plumage. It was clear, therefore, that the animals did not afford the
means of subsistence, and even if they were sufficient, how could
they be taken, for, excepting the pistols of François, there were no
fire-arms upon the island.
Mr. Bonfils reflected upon all these things, and he saw that unless
something could be done, poverty and misery must be the lot of the
people of Fredonia. If they had no clothing, no good houses, no good
furniture, no proper food, they would sink into a state of nature; they
would lose their refinement, their sense of propriety, their love of
neatness and order; they would, in short, cease to be civilized, and
become savages.
“How are these things to be remedied?” said one of the old men
to the governor. “I will tell you my views upon this subject,” said the
latter.
“It is by the labor of the hands alone that mankind can live, in a
civilized state. It is the labor of the hands that produces hats, shoes,
shirts, coats, gowns, handkerchiefs; the things we want to wear. It is
the labor of the hands that produces houses, and the furniture with
which we supply them. It is the labor of the hands that produces
wheat, rye, oats, barley, maize, potatoes, peas, and other things, as
food for man and beast.
“Now where the people are industrious, all these things which we
want for dress, for shelter, for furniture, for food, become abundant;
where the people are industrious, therefore, they are not only
supplied with the comforts and luxuries of life, but they adopt good
and virtuous habits, and are therefore happy. Where they are
indolent they are poor, vicious and unhappy. The great thing in
government, then, is to make people industrious. And now how is
this to be done?
“I do not know of any other way than to set before them
inducements to labor; we must see that those who work are well
rewarded for it. Here lies the great difficulty of our condition; we shall
soon be in want of food and shelter, and we shall all work hard
before we starve or go without houses. But when these pressing
necessities are supplied, shall we not relapse into indolence, vice
and barbarism?
“The first thing to be done is, no doubt, to look out for food and for
shelter; but we must go farther; we must try to keep up the tastes of
the people; we must try to preserve their love of good clothing; their
love of good houses; their love of good food, and the other comforts
and luxuries of home; the refinements and enjoyments which flow
from neatness and order. We must preserve these tastes, because
the people will toil to gratify them; they will become industrious to
gratify them. Without these tastes people will only work for food; they
will live like mere animals, being content with satisfying animal
wants; they will become savages.
“Refined tastes constitute what we call civilization; they raise men
above savages; they are the source of that industry which makes a
nation rich and happy. I repeat, we must preserve these tastes, we
must preserve our civilization.
“Now, in order to preserve these tastes, we must have the means
of gratifying them; we must have manufactories, to make bonnets,
shoes, and dresses; we must have agriculture, that is we must
cultivate the lands, in order to have bread and rear cattle; we must
have vessels to carry on commerce, by means of which, we may
exchange our products for tea, coffee, spices and things which do
not grow among us, but are produced in other lands. Thus
manufactures, agriculture, and commerce, are the three great
sources of prosperity; and these must be made to flourish, in order to
make people happy. How is all this to be done?
“The first step is this, to divide the lands and other property, giving
to each man his share, and making him secure in the possession of
it; and also making him secure in the possession of all he earns by
his industry or skill.”
Here the man broke in and said—“Pray excuse me, Mr. Governor,
but I differ with you there. I think it is better to hold the land and
everything else, in common. If you divide the land and property,
some persons who are greedy, sharp-witted and industrious, will
constantly increase their lands and property and become rich; while
others, who are simple, and careless, will gradually become poor.
Thus we shall soon see those odious distinctions of rich and poor in
society. I am opposed to all this!”
“I am well aware, my friend,” said the governor, “that such ideas
as you entertain, have often been indulged, and by very good people
too; but let me tell you that all attempts to put them in practice, have
resulted in disappointment and failure. No society that has held
property in common, has ever been happy; no society has ever
advanced in virtue, or civilization, or peace, that has been founded
upon this principle. Man loves to call things ‘mine,’ and ‘thine.’ Man is
made by his Creator to identify things with himself, and to love them
from such identity. Why, if all things are to be held in common, why
does the mother, why does the father, love the child? It is not
because it is more beautiful than other children, but because it is
theirs? Why is man made to love that place which goes by the dear
title of home? Why do we love our birth-place above all others, even

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Finance for Executives: Managing for

Value Creation 6th Edition Gabriel

The Innovation Ecosystem as a Source of Value Creation:

Strategic Leadership for Business Value Creation:

International corporate finance : value creation with

Digital Marketing Strategies for Value Co-creation :

Strategic Corporate Social Responsibility: Sustainable

Business & Professional Ethics for Directors,

Value Creation for Owners and Directors: A Practical

Training in Interpersonal Skills: TIPS for Managing

PV 5 3 CF1 3 DF1,k 4 1 . . . 3 CFt 3 DFt,k 4 1 . . . 1 3 CFT 3 DFT,k 4

5. Present value of an annuity (Chapter 2, equation 2.11)

6. Sharpe ratio of asset i (Chapter 3, equation 3.8)

Cov 1 Ri, RM 2 riMsisM si

Invested capital 5 Cash 1 Working capital requirement 1 Net fixed assets

10. Capital employed (Chapter 4, equation 4.6)

WCR 5 3 Accounts receivable 1 Inventories 1 Prepaid expenses 4

15. Return on invested capital before tax (Chapter 6, equation 6.4)

EBIT EBIT Sales

16. The structure of a firm’s return on equity (Chapter 6, equation 6.9)

EBIT Sales EBT Invested capital EAT

SGR 5 Profit retention rate 3 Return on equity

18. Net present value (Chapter 7)

19. Bond price (Chapter 10, equation 10.2)

21. Constant dividend growth model (Chapter 10, equation 10.10)

23. Equity (levered) beta (Chapter 12, equation 12.6)

24. Weighted average cost of capital (Chapter 12, equation 12.12)

26. Market value of a levered firm (Chapter 13, equation 13.4)

27. Market value at risk (Chapter 15, equation 15.1)

MVR 5 3 Reduction in the firm’s value if the risk will occur 4

C0 1 call option 2 5 S0N 1 d1 2 2 Xe2R TN 1 d2 2 F

P0 1 put option 2 5 Xe2R T 3 1 2 N 1 d2 2 4 2 S0 3 1 2 N 1 d2 2 4

30. Market value added (Chapter 18, equation 18.1)

Market value added 1 MVA 2 5 Market value of capital 2 Capital employed

31. Return on invested capital (Chapter 18)

32. Economic value added (Chapter 18, equation 18.6)

EVA 5 3 Return spread 4 3 Invested capital 5 3 ROIC 2 WACC 4 3 Invested capital

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PART ii Assessing Business Performance 99

PART iii Making Investment Decisions 227

PART iV Making Financing Decisions 315

PART V Making Business Decisions 487

PART i Financial Concepts and Techniques 1

chapter 2 The Time Value of Money 31

Appendix 2.1 Proof of Formula 2.9 and Formula 2.6 49

chapter 3 Risk and Return 53

Appendix 3.1 How to Get the SML Equation 93

PART ii Assessing Business Performance 99

Appendix 4.2 Specimen Financial Statements 136

chapter 5 Analyzing Operational Efficiency and Liquidity 153

A p p e n d i x 5 . 1 Financing Strategies 173

A p p e n d i x 5 . 2 The GlaxoSmithKline Liquidity and Operational Efficiency 176

chapter 6 Analyzing Profitability, Risk, and Growth 189

A p p e n d i x 5 . 2 The GlaxoSmithKline Liquidity and Operational Efficiency 176

chapter 1 6 Understanding Forward, Futures, and Options and Their

A p p e n d i x 1 7 . 1 Translating Financial Statements with the Monetary/

A p p e n d i x 1 8 . 1 Adjusting Book Values to Estimate the Amount of Invested Equity