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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)

$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

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

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

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

sixth Edition

Gabriel Hawawini
INSEAD

Claude Viallet
INSEAD

Australia • Brazil • Mexico • Singapore • United Kingdom • United States

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.
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
copyright herein may be reproduced or distributed in any form or
Publisher: Annabel Ainscow by any means, except as permitted by U.S. copyright law, without
List Manager: Jenny Grene the prior written permission of the copyright owner.

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British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

ISBN: 978-1-4737-4924-5

Cengage Learning, EMEA

Cheriton House, North Way
Andover, Hampshire, SP10 5BE
United Kingdom

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Printed in China by RR Donnelley

Print Number: 01 Print Year: 2019

This edition of Finance for Executives is dedicated to the memory of

Claude Viallet, my friend, colleague and co-author.
Gabriel Hawawini, 2019

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.
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
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.
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
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.
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
Self-Test Questions 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

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

Self-Test Questions 94
Review Questions 95

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
The Statement of Cash Flows 121
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
The Statement of Cash Flows 127
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

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
Self-Test Questions 145
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
Self-Test Questions 180
Review Questions 182

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
Self-Test Questions 219
Review Questions 222

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

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
Self-Test Questions 256
Review Questions 257

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
Self-Test Questions 282
Review Questions 283

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
Self-Test Questions 308
Review Questions 310

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

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
Self-Test Questions 354
Review Questions 355

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

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
Self-Test Questions 406
Review Questions 407

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
Self-Test Questions 439
Review Questions 440

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

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
and No Financial Distress Costs) 460
Effect of Borrowing on the Cost of Capital (with Corporate Income Tax
and No Financial Distress Costs) 461
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
Self-Test Questions 484
Review Questions 485

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

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
Self-Test Questions 525
Review Questions 526

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

Key Points 551

Further Reading 552
Self-Test Questions 552
Review Questions 553

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

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
Self-Test Questions 602
Review Questions 605

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

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
Self-Test Questions 647
Review Questions 648

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

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
Self-Test Questions 683
Review Questions 685

Answers to Self-Test Questions 691

Glossary 741
Credits 763
Index 765

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

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.

• 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-

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?

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?

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.

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

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

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

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

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.
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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
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.
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.

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).

“But how the subject theme may gang,

Let time and chance determine;
Perhaps it may turn out a sang,
Perhaps turn out a sermon.”—Burns.

A N eminent artist, a member of the Royal Scottish Academy, who,

although well up in the seventies, and feeling many of the
infirmities of advanced age, still continues to enrich the world by
as charming landscapes and crisp sea-pieces as he produced in his
younger days, was showing me some of his sketches from nature,
many of them bearing traces of repeated handling. His face
brightened up when a well-thumbed favourite was lighted on
amongst the promiscuous contents of the old portfolio. With his eye
fixed on the sketch, and his hand moving as if either the pencil or the
brush were in it, he told with animation where he made this sketch or
took that “bit.”
“Ah!” said he, “painting is a difficult, a very difficult
thing; in fact, it’s just made up of ‘bits’—just bits. A THE
something takes your eye,—a nook, a clump of trees, ARTIST
often a single tree, a boulder, or rocks (grand effects of AND HIS
light and shade on rocks)—ay, even the shape or tinge “BITS.”
of a cloud. Well, to work you go, and down with it.—There,” said he,
as he lifted what seemed a mere scrawl on a half-sheet of old note-
paper, “I took that at the Bank door. I was struck with the effect of the
sunlight on water falling over a barrel that a man was filling in the
river, and thought it would make a nice picture. I got that bit of paper
out of the Bank, took off my hat, laid the paper on it, sketched it off in
—oh! less than five minutes, and put it on canvas next day. There’s
another. I did that bit on the leaf of my fishing pocket-book at
Makumrich, near old Gilston Castle. Now there,” said he, taking up a
rough-looking, unfinished sea-scene in oil, “that has been a very
useful bit. I was sketching North Berwick Harbour, when all at once I
was struck with an effect of light and shade on the sea. I was able to
hit it exactly;” and as he said this, he moved his head from side to
side and scanned the picture, saying, “That bit has been of great use
to me, although I have never made a finished picture of it. The
‘effect,’ the gleam, the tone are as nearly perfect as possible. Ah,”
continued he, laying down the sketch, and turning to his easel, on
which lay a snow scene,—an old thatched cottage, in my opinion
quite finished,—“now there’s lots of bits to work up in that picture.”
And sometimes shaking his brush, and sometimes whirling it in a
very small circle close to the picture, but never touching it, he said,
“There—and there—and perhaps there. Ah! nobody would believe
what a labour it is to make a good picture, with all the bits and bits!”
I am but an aspirant in literature, and would never presume to
compare myself with the veteran artist, or think that I could ever
arrange my bits of village gossip and incident with the artistic skill
which has earned for him the order of merit that he has so
honourably won and so worthily wears, but I confess to a desire to
present some of the bits of the everyday social life of Blinkbonny in
such a form as to give my readers an idea of its lights and shadows.
Blinkbonny is more of a village than a town, although it is generally
spoken of by the outside world as a town, owing to its having its
small weekly market and occasional fairs. It lies fully thirty miles
inland from Edinburgh, and is the centre of a good agricultural
district, with a background of moorland and hills. My father was a
merchant in it,—a very general merchant, as he dealt in grain, wool,
seeds, groceries, cloth, hardware, and various other commodities.
This may seem a strange mixture in these days of the division of
labour and subdivision of trades, but such dealers were not
uncommon fifty years ago, and they were frequently men of
considerable capital and influence. My elder and only brother was a
partner with my father in the business; and as I had early expressed
a desire to be a minister, I was sent to Edinburgh to prosecute my
studies in that direction, and had completed my fourth session at
college, when the death of my brother rendered it necessary that I
should do all in my power to supply his place.
I had been but a few months at home, when my father,
whose health had been failing for some years, became THE
a confirmed invalid. My brother’s death had not only FOLKS AT
affected his spirits, but injured his health, and within GREENKN
OWE.
little more than a year after this heavy trial the old man
was laid beside his wife and eldest son in the churchyard of
Blinkbonny. My sisters, all of them older than myself, were married,
excepting Maggie; and about a year after my father’s death Maggie
became Mrs. McLauchlan, so that I was left a very young inmate of
Bachelor Hall. When I had time to feel lonely I did so, but the
demands of business kept me thoroughly employed; and although I
joined habitually in the socialities of the neighbourhood, I did not
seriously think of getting married until I was called on to act as
bridegroom’s man to my schoolfellow and college companion, John
McNab, now the Reverend John McNab. He married Mary Stewart of
Greenknowe, the daughter of a small proprietor on the outskirts of
our village. Her sister Agnes was bridesmaid, and we were
necessarily brought a good deal into one another’s society. I had
often met her before, and liked her in a general way, but at her
sister’s marriage I came fully under the influence of her charms.
There was something—well, something—I cannot describe it by any
other word than just “something”—that fairly possessed me. For
days afterwards she was in my head, in my dreams, in my heart. I
will not describe our courtship; it was neither long nor romantic. I
wooed and won her, got Mrs. Stewart’s consent, and on New Year’s
Day 1841 we fixed that our marriage should take place in the last
week of January.
Mrs. Stewart felt the cold weather severely, and could not venture to
call at the manse to request Mr. Barrie, our worthy parish minister, to
perform the ceremony. She asked Agnes to go in her stead, but
Agnes could not muster courage to do so—she even felt too shy to
write to Mr. Barrie; so, although it was not exactly according to the
strict rules of etiquette I promised to call on Mr. Barrie next day, and
to arrange the matter with him.
Blinkbonny. (Page 6).
The manse stood on the top of a piece of slightly rising ground,
about a quarter of a mile to the south-west of the village. The
situation was a pleasant one. It commanded on three sides
extensive views of a well-cultivated country, backed by high and
picturesque hills; the village bounded the view on the north-east.
Near the manse stood the neat church, surrounded by the
churchyard. There were also a park of about four acres, a garden
covering nearly an acre, and some outhouses, the whole enclosed
by a compact wall.
I had been on intimate terms with all the inmates of the
manse, from Bell, the only and worthy servant, THE
upwards; but my errand made me feel rather INTERRUP
confused, and instead of the usual off-hand remark to TED CALL.
Bell, varying from, “Weel, Bell, hoo’s a’ wi’ ye?” to
comments on the weather or crops, as suited the season, I bluntly
asked if Mr. Barrie was engaged. There was a flavour of tartness in
Bell’s manner as she replied, “Mr. Barrie’s aye thrang, but he’s aye
ready to see onybody that wants him partic’larly. I’ll speir at him if
he’s engaged,” and she disappeared. Mr. Barrie himself came to the
door, shook hands with me with more than usual heartiness, put a
special emphasis on the happy in wishing me “a happy New Year,”
gave my hand a sort of squeeze, took a long look at me, and with a
smirk on his face said, “Come in, Mr. Martin, come in.” He had not
called me “Mr.” before, but only plain Robert; and from the blithe way
in which he showed me into the “study,” I saw that he knew my
position, if not my errand.
Our conversation was at first general, and on my side jerky. I did not
follow up intelligently the subjects he introduced, but was either silent
or rambling on quite irrelevant topics. He made a long pause,
doubtless to induce me to lead, as he evidently saw I was not able to
follow. The not uncommon weakness of Scotchmen, of trying to
conceal strong emotions even on subjects on which they feel very
keenly, was working in me. I was heart-glad at the prospect of my
marriage, and well I might; but I wished to appear very cool, so, as if
merely beginning another subject, I said in a conversational way, “I
was once thinking of getting married.” Scarcely had I finished the
sentence, when Bell announced that Sir John McLelland would like
to speak to Mr. Barrie when he was disengaged. Knowing that Sir
John was the largest landowner in the parish, and the patron of the
church, and that he was taking an active part in a church extension
scheme in which Mr. Barrie was deeply interested, I at once left the
“study,” stating that I would call to-morrow night, and made for
Greenknowe, where I was bantered by both ladies, but especially by
Mrs. Stewart, when I told about “once thinking of getting married.”
Laying the emphasis first on the once, then on the thinking, then on
both, she said, “Is that all the length you are? You should think twice
—second thoughts are often best. Agnes, if you had either called or
written as I wished, we could have had the invitations out to-day; but
perhaps Robert will take the second thought to-night, and until he
quite makes up his mind we must wait with patience.”
Next night found me at the manse door, which Bell
“answered.” I was very frank, but Bell had barely THE NEXT
digested last night’s slight, and before I had finished VISIT TO
my salutation to her she said dryly, “It’ll be the minister THE
MANSE.
ye want the nicht again?” and showed me into the
study. Mr. Barrie, after expressing regret at the sudden breaking up
of our last night’s interview, asked me if the day had been fixed. I told
him that we would prefer the last Tuesday of January, if that date
suited him. He at once said, “I’ll make it suit me;” and after noting it
in a memorandum book, he proceeded, although I had not
mentioned the name of my future wife, to speak very nicely of the
good folks at Greenknowe; of the late Mr. Stewart, who had been
one of his elders, and from whom, in the earlier years of his ministry,
he had received much useful counsel; of Mrs. Stewart’s almost
motherly kindness ever since he came to the parish; of his great
esteem for Miss Stewart (my Agnes), and of her devotion to her
father, especially in his long and last illness. He also spoke of my
late father and brother as excellent, very excellent men, said some
things about myself which I will not repeat, and taking me by the
hand, said, “Humanly speaking, your marriage promises to be in
every respect a happy event for all concerned. May God bless you
both, and make you blessings to one another, to all your circle, to the
Church, and to the world.”
I thanked him warmly, and added that I might trouble him by asking
his advice on some matters, and possibly Mrs. Barrie’s; and was
proceeding to bid him good-night, when he said, “Robert, this is an
occasion, I may say a great occasion, and you must take an egg with
us. I told Mrs. Barrie last night that you were ‘once thinking of getting
married.’ She will be delighted to learn that your second thought has
got the length of fixing the day. And, whilst I am in the habit of giving
all young bridegrooms a few quiet hints, I would like you to have a
chat with both of us. You will find Mrs. Barrie’s counsel sound and
practical, so we’ll join her in the parlour;” and suiting the action to the
word, he lifted the lamp, and asking me to follow him, made for the
snug parlour, where he announced me as “a subject of compound
interest now, not simple as before.”
Mrs. Barrie was carefully darning a stocking, which she laid on the
table as I entered, and shaking my hand with great heartiness, she
said, “I need hardly wish you a happy new year, Mr. Martin. You are
as sure to be happy as anybody can be sure of happiness in this
world. I hope you consider yourself a very lucky man?”
I made as nice a reply as I could. Mrs. Barrie repeated her
husband’s “You must take an egg with us;” and laying the half-
darned stocking into her work-basket on the back table, she looked
into a cradle that stood in the cosiest corner of the room, and seeing
that all was right there, she said, “I must see that the other little folks
are happit before I sit down,” and left the room. But before I tell of the
evening’s quiet enjoyment in the manse parlour, I will say something
about the inmates of the manse itself.
Mr. Barrie was ordained as minister of Blinkbonny in
1830, and early in 1831 he brought his young wife, till THE
then Mary Gordon, home to the manse. He was a son INMATES
of the manse, a son of the minimum stipend; when half OF THE
MANSE.
through his preparatory studies he became a son of
the Widows’ Fund. Mrs. Barrie’s parents had been in a very
comfortable worldly position for the first sixteen years of her life, but
through circumstances over which they had no control, and to which
she never referred, their means had been greatly reduced. Her
father died when she was eighteen years of age; her mother
survived her father about four years. She was thus an orphan at
twenty-two. She was twenty-five years of age when she was
married, Mr. Barrie being her senior by fully one year; and whilst she
brought to the manse “a good providing,” she brought little money or
“tocher,” as a bride’s marriage portion is called in Scotland. The
income of the minister of Blinkbonny, or, to use the church phrase,
the “stipend,” was paid partly in money and partly in grain, and
averaged about £160 yearly. The furnishing of the manse and the
minister’s library had required and received careful consideration.
Even the providing of live stock for the park, to commence with,
involved an outlay that in the circumstances was considerable; but
by Bell’s indefatigable industry and management, the cow, the hens,
the garden, and even the pig became such important sources of
supply in the household economy, that any description of the
inmates of the manse would be utterly incomplete which did not
make honourable mention of worthy Bell.
Bell had come with Mrs. Barrie as her first servant, and had grown
up as, if not into, a part of the family. She was fully the middle height,
muscular, not stout but well-conditioned, had a good complexion, a
“weel-faured” face, keen, deep-set, dark eyes; and altogether she
was a comely woman. I believe her full name was Isabella Cameron,
but she was only known as Bell, occasionally Mr. Barrie’s Bell; so
much so that when a letter came to the manse, addressed “Miss
Cameron,” both Mr. and Mrs. Barrie had laid it aside, expecting that
some stranger would call for it, and were instructing Bell to return it
to the post office in the evening, should no Miss Cameron cast up,
when Bell said, “My name’s Cameron; it’ll maybe be for me.” It was,
much to Mrs. Barrie’s embarrassment, and told of the death of Bell’s
aunt. Bell had few relations,—none that seemed to care for her, and
consequently none that she kept up intimacy with.
She was a year older than Mrs. Barrie. Her first “place”
had been in a small farmhouse, where the manners BELL OF
were very primitive, and the work was very constant. THE
MANSE.
One of her questions shortly after coming to the
manse was, “Does Mr. Barrie aye take his dinner with his coat on?” a
thing she had not seen before. Mrs. Barrie had a little difficulty in
getting her to understand the proprieties, but none in getting her to
do exactly as she was told. Bell felt nothing a bother, took pleasantly
any explanation given as to her mistakes, laughed at them when
pointed out, and with a cheerful “I’ll mind that,” thanked Mrs. Barrie.
It took her some time to learn the distinctive tones of the bells, the
parlour, dining-room, front door, etc.; and for the first week or two,
when a bell was rung, she ran to the nearest room and tried it, then
to another, sometimes to the disturbance of the folks inside; but she
soon came to know them.
It was a sight to see Bell unbuckle her gown,—which when at work
she gathered round her, and fastened in some wonderfully fast-loose
way,—shake herself, and stalk off in response, especially to the front
door, to any ring that seemed peremptory.
Sir John McLelland was making his first call after the marriage. He
handed Bell his card, politely asking at the same time if Mr. and Mrs.
Barrie were at home. Bell looked at the card, but it was in German
text, and therefore unintelligible. She looked at Sir John, but that did
not help her; she then turned on her heel,—the swiftest, cleverest
motion of the kind that could be imagined,—walked briskly to Mrs.
Barrie, and said, “There’s a man at the door, a weel-put-on man, and
he asked for you; an’ he gied me a ticket, an’ he’s there yet.”
Mrs. Barrie soon put such mistakes right. She found Bell an apt
scholar, scrupulously clean, sterlingly honest, and always busy,
though not fussy. At first Bell was most at home among the hens,
cows, pigs, and in the garden, but she soon became well up in all
household work. Even the addition of the children one by one never
seemed to tax Bell’s powers heavily. The first two, James and Mary,
were healthy, and in Bell’s homely phrase, “never looked behind
them;” but the third, “Wee Nellie,” had been from her birth “a feeble,
delicate little thing.” When she was about three years old, scarlet
fever attacked the children, beginning with Lewis, the baby. His was
a mild case; so were those of James and Mary, but Nellie’s was a
severe one. Her pulse ran very high, her little body was covered with
the bright scarlet “rash,” her throat sorely affected, her breathing
laboured and requiring more effort than the weak constitution could
spare. Mrs. Barrie and Bell were unwearied in their efforts to relieve
the poor sufferer, and gently was she passed from knee to knee in
her restless moods, gently was she laid down again, and coaxed and
humoured and waited on with unspeakably tender care.
Between Bell and Nellie there had been a special
intimacy. She had called herself “Bell’s bairn;” and as BELL AND
her age and health did not admit of her joining the WEE
other children at play, she was seldom out of the NELLIE.
kitchen, except when Bell wrapped her cosily in a
plaid, and carried her about the parks or garden, where Bell diverted
herself quite as much as the “wee whitefaced girlie,” by humouring
her childish whims, and joining in, if not provoking, her wondering
interest. And ever and anon, as Nellie expressed delight at what Bell
said, or did, or pulled, or showed, Bell would press her warmly to her
breast, and croon over words of endearment about her “wee
croodlin’ doo,” “her ain darling Nellie,” “she was Bell’s bairn,” and tell
her that when she was big she would help Bell to milk “Daisy,” and
feed the hens. The cosiest corner in the kitchen was Nellie’s
“housie.” There she would play for hours, sometimes sitting on her
little stool, and chatting with Bell “like an auld body;” sometimes
fondling her black-and-white kitten Tibby; sometimes putting to sleep
her favourite doll “Black Tam,” who, although he had neither arms
nor legs, and his trunk had by long wear lost the black paint, and
appeared as bare timber well time-soiled, still retained on his head,
which had been gouged out to imitate the woolly hair of the negro,
crescent-shaped indents of his original blackness, and his lips were
flecked with streaks of their primitive crimson; sometimes playing
with broken bits of china, drawing Bell’s attention to those with gold
on them as “Nellie’s pennies.” And not infrequently did Bell take the
wee lassie into her kindly lap, and press her to her kindly bosom,
and sing, and sigh as she sung, her favourite if not only song of the
“Bonnie, bonnie banks of Benlomond.”
It need hardly be recorded that Bell’s agony at Nellie’s illness was
only equalled by that of Mrs. Barrie,—possibly by that of Mr. Barrie,
but only possibly. She had been struck with the hectic
flush which glowed on Nellie’s face, and saw that the “WEARIN’
fever was sore on her; but she hoped against hope, AWA’.”
until on the seventh day of the illness a spasmodic
movement of the weak body, and a hazy gleam of the weary eye,
revealed to Bell that Nellie’s recovery was hopeless. The thought of
losing her came so suddenly on Bell, that she nearly broke down in
the room; but restraining herself as her eye rested on Mrs. Barrie’s
calm motherly face, intent on anticipating and ministering to the
wants of the sufferer, Bell whispered that she would “see if the bairns
were all right, and be back immediately,” and left the room. She
walked noiselessly through the lobby, at the darkest corner of it gave
two or three great “gulps,” and uttered a bitter “Oh! dear, dear.” This
was what nature demanded; this at least, more if she could have got
it; but this little snatch relieved her pent-up heart, and braced her for
further service. After seeing that the other children were right, she
glided into the sick-room, from which Mr. Barrie, with a remark or
rather a sigh about “too many breaths,” emerged as she entered.
She took the fever-tossed child gently out of Mrs. Barrie’s wearied
arms, and did her best to relieve the difficulty of breathing, so
harassing to the watchers, and so sore on the patient. Gradually the
fitful struggles became less violent; Nellie got quieter, softer,
powerless. She half opened her eyes, then closed them slowly, and
said in a faint voice, with a long eerie tone, “Bell.” Bell, half choking
with grief, bent over her and kept saying, “Yes, ye’re Bell’s bairn,
ye’re Bell’s ain bairn;” but observing her weary, weary face and
increasing softness, she looked wistfully at the invalid, then
sympathizingly at Mrs. Barrie, and, rising softly, laid the wee lamb on
Mrs. Barrie’s lap, slipped noiselessly to Mr. Barrie’s study, and
opening the door very slightly, said, “Please, sir, come ben, or the
angels will be before you!” She got another gulp as she waited to
follow him into the sick-room, and that helped her greatly. The little
darling recognised “papa,”—smiled as she lisped his name,—smiled
if possible more sweetly as she heard her mother’s voice, in
quivering accents, saying, “My ain wee wee Nellie!” and sighed
audibly, “Mamma’s wee-wee,”—she then closed her eyes, and in the
act of raising her tiny hand to her throat, it fell powerless, and Wee
Nellie was Wee Nellie no more, or rather, as Bell said, Wee Nellie for
ever.
Her delicate health and consequent helplessness, as
also her gentleness, had endeared her to Mr. Barrie. “THE
When all was over, he muttered, “She was a pleasant LAND O’
child, lovely and beautiful in her life;” and added in a THE
firmer voice, “It is well with the child, it is well.” Bell LEAL.”
lifted the little body from its mother’s lap, and laid it gently on the
bed. Her tears were streaming, but she had got the first bitter pang
over, and putting her arm on, or rather round, Mrs. Barrie’s shoulder,
she said, “Come away, mem, for a little; I’ll put all right.” Mrs. Barrie
obeyed mechanically, and was persuaded by Bell to lie down in bed.
There wearied nature asserted her prerogative, and she slept
soundly for a considerable time. When she returned to the sick-
room, all traces of illness, in the shape of couches, baths, phials, and
confusion, were away; the old crumb-cloth which had been put down
to preserve the carpet was exchanged for a clean linen drugget; the
fire was out, the fire-place filled with fir-tops; the window was open,
and the blind drawn down; here and there about the room were little
muslin bags filled with lavender-seed; and on the mantelpiece,
which, when she left, was covered with tumblers and cans and
glasses of medical stuff, overlapped with paper, or having spoons in
them to the hazard of their balance, stood three tumblers filled with
bunches of lavender; and on the bed lay all that remained of Nellie,
“dressed and laid out,” her little body making all the more
appearance that the snow-white bedcover was tightly laid over it. On
her face lay a muslin handkerchief, kept down by a bag of lavender
on either side.
As Mrs. Barrie approached the bed, Bell walked to the other side of
it, and slowly folded down the face-cloth. All traces of suffering and
weariness had vanished; the face was that of a child smiling in sleep.
“Bell,” said Mrs. Barrie, “she’s beautiful” (she had never said that
before of her or of any of her children), “beautiful,—and she’s home.
Of such is the kingdom of Heaven.” Bell tried to speak. She got the
length of faltering out, “For ever with the Lord,” when Mrs. Barrie
stooped down to kiss her “lost lamb.” Bell rather quickly folded the
face-cloth over the mouth, saying, “On the cheek or the broo, mem,
no’ on the mooth.” Although Mrs. Barrie’s frame shook as her lips
touched the cold brow, she pressed them on it lingeringly, and as
she raised herself she said, “I will go to her, she cannot return to
me.” Then, looking round the room, she said, “Bell, O Bell! I can
never repay, and I will never forget, your kindness at this time.” She
would have said more, but Bell broke down, and Mrs. Barrie broke
down, and both were considerably better when the pent-up flood of
sorrow found relief.
In the churchyard of Blinkbonny stands a little marble slab, only a
few inches above the ground bearing the following inscription:—

HELEN BARRIE
DIED 18TH MAY 1838, AGED 3 YEARS.
——
WITH CHRIST ... FAR BETTER.

“THE
The spot had no more constant visitor than Bell. The
BUTTERFL flowers that in their seasons grew round it were
Y ON A planted by her hand, and tended by her with
GRAVE.” constant care; the only difference being that in
weeding or trimming it there was not the quick,
bustling energy which she exercised in the garden, but a reverent
slowness unusual for her. She never put her foot on the sod under
which Nellie lay; and although for the first few visits she sighed
mournfully as she read the inscription (and she read it aloud to
herself at every visit), it was not long before her face lightened as
she uttered the last two words, and she would add in a cheerful
confirmatory tone, as if Nellie herself had repeated the epitaph, “Yes,
Nellie; yes, Bell’s bairn, far better; far, far better.”

“A butterfly bask’d on a baby’s grave,

Where a lily had chanced to grow;
‘Why art thou here with thy gaudy dye,
When she of the blue and sparkling eye
Must sleep in the churchyard low?’

Then it lightly soared through the sunny air,

And spoke from its shining track:
‘I was a worm till I won my wings,
And she whom thou mourn’st, like a seraph sings;
Wouldst thou call the blessed one back?’”

Mrs. Sigourney.
CHAPTER II.
A QUIET EVENING AT THE MANSE.

“Thrift made them easy for the coming day,

Religion took the fear of death away;
A cheerful spirit still ensured content,
And love smiled round them wheresoe’er they went.”

Crabbe.

I NEED hardly tell that between Mrs. Barrie and Bell the relationship
of mistress and servant was more than cordial, more than intimate,
—I can find no better word to express it than perfect. To say that
Bell knew her place is a term much too bald; she filled it, fulfilled it,
full-filled it. She was devoted to the family’s interest; her heart and
mind were in her work; she had a clear head, a strong arm, a blithe
happy manner, and an uncommonly large stock of common sense.
She had a ready “knack” of dividing the articles under
her care, by a sliding scale of her own, so as to put all BELL’S
to the best use: she laid aside some for the dining- SLIDING
room on “company” days, and even at a sudden call SCALE.
she was seldom found unprepared; some for the
parlour, to suit old and young (for there was no formal nursery in the
manse,—Bell’s room, “off” the kitchen, was best entitled to the name,
although competing claims might have been put forward by the
kitchen itself, the parlour, and even the study); some for the kitchen,
but that had not a high place in her scale; a good deal for the poor,—
plain, handy, and given in good time and with discernment. Of one
thing she was very careful, and that was, that if any food seemed
likely to spoil, it was given away before it went wrong; if any clothing,
it was given clean, and although often well patched, it was fit for
immediate use. There was a corner in the kitchen pantry with a stock
of comforts, and even luxuries, for cases of sickness, old age, or
special need. The dumb animals were studied with thoughtful care,
and they repaid it well. Everything that could be used was used
regularly and methodically.
Bell’s dress varied with her work. In the morning she
“sorted” the live stock, clad in what an artist would THE BUSY
have called a grotesque or picturesque costume, BEE.
according to the season. In winter her upper garment
was an old overcoat of Mr. Barrie’s—a “Spencer;” in summer it was a
loose-fitting jacket of striped cotton, lilac and white; her linsey-
woolsey petticoat was of the right length for such work, and all were
shaken or brushed or beaten daily. She put on her cotton “morning
wrapper,” of blue with small white spots, just before she “set” the
breakfast, and got “redd up” for the day in time to serve up the
dinner. While she had her set times for her regular work, and “turned
her hand” smartly to anything more pressing, she observed no
“Factory Act” restrictions as to her hours of labour. Very early in the
morning the clank of Bell’s “pattens”[1] was heard as she attended to
her home farm, and till far on in the evening she was working away
anxiously and cheerfully. Her rest was a change of work on week-
days. On the Sabbath afternoon she took what seemed likest a rest,
viz. a walk round the whole premises, leisurely, observant,
inquisitive, noticing everything, and mentally noting a good deal for
next week’s attention; varied by an occasional “saunter” into the
gardens of the neighbours for purposes of observation, comparison,
insight, or exchange.

[1] Pattens were a primitive form of what are now known as

overshoes, although “undershoe” defines the patten more
correctly. The upper part was made of wood, like the frame
of an ice-skate, but broader,—not unlike the frame of an
oval horse-brush; and it was put on by pushing the foot
firmly into overstraps made of leather or “girth cloth,” in the
same way as a horse-brush is fixed on a groom’s hand. The
under part was an oval-shaped ring of thin iron, measuring
about six inches long, four inches broad, and one inch deep.
There being no fastening at the back, the heel of the
wearer’s shoe made a “slip-shod” noise on the wooden sole,
which, added to the clanking of the iron soles, especially on
any pavement or causeway, produced a double-beat
“clatterin’ clatter.” To the inexperienced they were as difficult
to walk with as skates are; they kept the foot about two
inches from the ground, and were taken off before entering
the house by merely withdrawing the foot. They not only
kept the feet dry, but a “clean hoose.”

Her respect for Mr. and Mrs. Barrie was profound: they were the
handsomest couple in the parish, and many parishes might have
been gone over before a more comely, gentle, ladylike, person than
Mrs. Barrie could be met with. Bell said, “They were, if that was
possible, better than they were bonnie;” and when Mrs. Barrie told
Bell, as she often did, to rest and take things more leisurely, Bell
would say, “I like to work, mem, I like it; I canna be idle.” Mrs. Barrie’s
remonstrances were firmer on extra occasions, such as a “heavy
washing,” but Bell’s answer was, “It was naething, naething at a’;
and didna we get a grand day for drying the claes?”—or at the
“Spring cleanin’,” when her answer was, “It’s best to get all the
confusion past and by wi’t. It was a nice thing a fresh, clean hoose;
—’deed, mem, it astonishes me to see hoo much cleanin’ every
place needs, although it’s no very bad like before you begin.”
I may be dwelling too long on Bell, and it is not at all unlikely that she
may become the heroine of my story, or rather the central figure
round which the “bits” are grouped. If so, I could not wish a better,
although Bell herself had no idea that she was such a good servant,
or that she did more than her bare duty; she oftener felt she had not
done as well as she wished. She was far too sensible and busy a
woman to think much about herself; and should she read this, she
would be the first to say “she wished she had done better,—he
hasna tell’d my fau’ts.” Worthy, kindly, honest Bell!
Mrs. Barrie’s housekeeping was the admiration, to
many it was the miracle, of the parish and district. She “GIVEN TO
was a good manager, and with such a helpmate as HOSPITALI
Bell, she made her income do wonders. To the poor, TY.”
the manse was always open for judicious help; the
hospitality of the dining-room and parlour was substantial and
becoming. This was all the more astonishing from the fact that Mrs.
Barrie was “such a delightful creature,” “such a charming person,”
“quite a lady,” “a model minister’s wife,” “so accomplished,” “so
amiable,” “so frank,” “so nice,” “so attractive” (these are actual
epithets used by her friends), that the number of visitors, many of
whom were easily persuaded to become guests, was larger than
was desirable, and the consequent calls on the larder and pantry
were heavy. Indeed, this was a subject of frequent remark among
those who enjoyed the hospitality of the manse, all wondering how
ever she could manage, and many “beseeching” Mrs. Barrie not to
trouble herself about them, as they only wished a quiet chat,
although the length of many of their visits made them more like
visitations; Mrs. A. and Mrs. B. suggesting that Mrs. C. and Mrs. D.
might be more considerate, whilst Mrs. C. and Mrs. D. were
surprised at the audacious manner in which Mrs. A. and Mrs. B.
thrust themselves on Mr. and Mrs. Barrie. It was really difficult to
withstand the attractions of the manse, and Mr. and Mrs. Barrie,
more particularly Mrs. Barrie, was made a social martyr because she
was so good, and kind, and true.
It never occurred to Mrs. Barrie that her good nature and good
housekeeping were inconsiderately drawn upon by many who should
have known better. She liked to see, and to contribute to, the
enjoyment of others, preferred being active to being passive in this
matter, and was “given to hospitality” from the genuine sweetness of
her nature; and while the sigh of weariness often escaped her lips at
the close of some of the nice “sociables,” which had been prolonged
so as to interfere with domestic and other duties, she never
murmured; although she and Bell had often to encroach on the hours
of rest or sleep in order to keep everything forward, and as they
would like it.
Mr. Barrie’s broadcloth was invariably fresh-looking, and his linen
faultless. Mrs. Barrie was at all times becomingly dressed, and in the
afternoons quite “the lady, aye sae genty.” The boys and girls were
comfortably and neatly clad every day, specially so on Sabbath days,
and theirs was a happy home.
Before I began to describe the inmates of the manse, I mentioned
that Mrs. Barrie said, on leaving the parlour, she was going to see if
the “bairns were happit.” She seldom spoke Scotch, but when she
did, it was with quaint emphasis and special sweetness. There was
no real need for Mrs. Barrie having any anxiety on this subject of
“happing,” as Bell was always on the alert; but Mrs. Barrie’s motherly
heart could not rest until she had seen, and kissed in their beds, her
“wee croodlin’ doos.” She went first to see Bell about the supper;
then to Bell’s room, where Mary and Flora were fast asleep; then to
her own room, where Lewis was sleeping soundly, but James wide
awake, scheming in his little head whether he could not make a pair
of skates, and wishing that Bell would come up, as her “pattens”
seemed the likeliest raw material to make them of, and he had seen
an old pair in the byre. Mrs. Barrie heard his story, and said they
would never do; but that Mr. Martin was in the parlour, and she would
ask him the price of a pair, if he would sleep like a good boy; and
kissing both, and “tucking” them in, she returned to the parlour.
During her absence, Mr. Barrie spoke to me in quite a
fatherly way. He knew that I had a good business and BE
fair prospects, but that, since my father’s death, I had “JUDEECI
bought a small property called Knowe Park adjoining OUS.”
the village, and that this had absorbed my available
means to such an extent as to render it a little difficult for me to carry
on business comfortably to the extent that my father had done. After
stating that he thought I was taking a wise step in getting married, he
said he found it generally the case, although it sounded like a
contradiction, that a married house was more cheaply and much
better kept than a bachelor’s; and that he was in the custom of
drawing the attention of folks who were about to get married to the
subject of Life Assurance, or, if working men, to Benefit Societies,
and to the necessity of economy and prudence in money matters.
“But,” added he, “you know these things better than I do, and I know
you will act judeeciously,” with a considerable emphasis on the ee.
And as he referred to the various relationships of social life, he
closed each section (for his advices unconsciously ran into “heads
and particulars,” like his sermons), with, in short, “Be judeecious;”
and so clearly did he illustrate the inseparable connection between
wisdom and success or happiness in everything he spoke of, that his
advice seemed then, and seems yet, summed up in, “Be
judeecious.” He will excuse me for telling here, that in the parish he
was not unfrequently spoken of as “Judeecious;” and after the lapse
of fully forty years, he is still occasionally styled, “Worthy old
Judeecious,” by some elderly warm friends, when recalling the sunny
memories of former days, although in general conversation he is
now spoken of as Dr. Barrie.
He related with considerable glee a saying of an old minister, who, in
speaking of money matters, used to maintain that there were only
three ways in which a minister could make money—patrimony,
matrimony, or parsimony. He also told the story, which is long ago
threadbare, of the old merchant, who, when asked why his son had
not done so well in business as he had, replied, “That’s easily
explained: we old folks began with a little house and a plain table,
with porridge and a herring, and got up to tea and a ‘chuckie’
(chicken); but the young folks began with a braw house, and tea and
chuckies and silks, and never buckled up their sleeves to work.”
When Mrs. Barrie joined us, supper was already on the table. After
glancing into the cradle, to see if all was right with “Gordie,” or
Gordon Lennox, as his full name was, she said, “Come away,
gentlemen,” and seating herself at the head of the table, did the
honours in a graceful and homely way.
Bell had brought in the little black kettle, and it kept
singing by the fireside. When the simple meal was “BAIRNS
over, Mr. Barrie and I made a “tumbler” of toddy each, WILL BE
a rare thing for him, but he said it was “New Year BAIRNS.”
time,” and an “occasion;” and my health was drunk,
and that of Agnes, in which Mrs. Barrie joined, a very rare thing for
her; and Mr. Barrie had just said, “Now, my dear, you must give Mr.
Martin the benefit of a little of your experience,” when the door-
handle was slowly turned, evidently by a less firm hand than Bell’s,
and a little head and part of a little white nightgown, appeared at the
half-opened door, and a voice was heard timidly saying, “Mamma,”
followed by Bell’s voice, which, with a mixture of astonishment and
anxiety in its tone, was heard saying, “James—here—at this time o’