Reading Essentials and Study Guide

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1 Lesson 2 Business Growth and Expansion ESSENTIAL QUESTION How are businesses formed and how do they grow? Reading HELPDESK Academic Vocabulary merger combination of two or more business enterprises to form a single firm internally existing or occurring from within Content Vocabulary income statement report showing a business s sales, expenses, and profits for a certain period, usually three months or a year net income measure of business profits determined by subtracting all expenses, including taxes, from revenues depreciation gradual wear on capital goods cash flow total amount of new funds the business generates from operations; broadest measure of profits for a firm because it includes both net income and noncash charges horizontal merger combination of firms producing the same kind of product vertical merger combination of firms involved in different steps of manufacturing or marketing conglomerate firm with four or more businesses making unrelated products, with no single business responsible for a majority of its sales multinational corporation producing and selling without regard to national boundaries and whose business activities are located in several different countries incubators places where entrepreneurs can receive the training to build a successful start-up business venture capitalist lender of investment funds to a start-up business in exchange for partial ownership of the business angel investors informal and usually affluent investors who provide start-up funds crowdfunding using social networking to appeal to potential investors 1

2 TAKING NOTES: Key Ideas and Details Use a graphic organizer like the one below to explain why one business would want to merge with another. Models for Business Growth Growth Model Description Reinvestment and Internal Growth Mergers and Acquisitions Growth Through Reinvestment Guiding Question Why would business owners choose to reinvest profits? Most businesses use financial reports to keep track of their business operations. One of the most important of these financial statements is the income statement, which shows sales, expenses, net income, and cash flows, usually for three months or a year. We can use the income statement to show how a business can use sales revenue to reinvest and grow. Estimating Cash Flows An income statement such as the one in Figure 8.4 shows a firm s net income, the funds left over after subtracting all expenses from sales. Besides taxes, expenses include the cost of inventory, wages and salaries, interest payments, and all other payments the firm must make as part of its normal business operations. One of the most important is depreciation, a value assigned to general wear and tear on its capital goods. This value is called a noncash charge because the money stays in the firm rather than being paid to someone else as when a firm pays wages to employees, for example. Current tax laws allow the firm to treat depreciation as an expense. This lowers the amount of income to be taxed. So the money set aside for depreciation never goes anywhere, but becomes part of the firm s income. Firms usually prefer to take as much depreciation as possible. As you see in the figure, an increase in depreciation lowers earnings before taxes, but increases the cash flow. The cash flow is the sum of net income and noncash charges such as depreciation. The cash flow is the bottom line, a comprehensive measure of a firm s profits representing the total amount of aftertax income produced from operations. Reinvesting Cash Flows If the business has a positive cash flow, the owners can then decide how to distribute it. A corporation s board of directors may decide to pay a dividend directly to shareholders as a reward for their investments. The corporation could reinvest the remainder of the funds in a new plant, equipment, or technologies. If the business was a proprietorship or partnership, the owners could keep some of the cash flow as a reward for risk-taking and then reinvest the rest. 2

3 When a firm reinvests cash flows in a business, the firm can produce new or additional products. This creates additional sales and an even larger cash flow during the next sales period. As long as the firm has positive cash flows, and has reinvested funds that are larger than the wear and tear on equipment, the firm will grow. Positive cash flow is also important to attract investment from outside the firm. When investors judge a firm s financial health, one of the first things they look for is a positive cash flow. Reading Progress Check Summarizing What is the benefit of reinvesting cash flow in a business? Growth Through Mergers Guiding Question What advantages are gained through business mergers? Another way a business can expand is by engaging in a merger, when two or more businesses combine to form a single firm. When two companies merge, one gives up its separate legal identity, continuing only in the name of the new company or its products. When Chase National Bank and Bank of Manhattan merged, the new company became the Chase Manhattan Bank of New York. As business expanded outside New York, the company renamed itself the Chase Manhattan Corporation. After merging with JP Morgan, it settled on JPMorgan Chase. Procter & Gamble kept the brand name Gillette for some products after it bought the company. Types of Mergers There are two types of mergers, both shown in Figure 8.5. The first is a horizontal merger, when the two firms produce the same kind of product, like the two banks JP Morgan and Chase Manhattan. Sometimes companies involved in different stages of manufacturing or marketing join together in a vertical merger. At one time U.S. Steel, the result of many mergers, mined its own ore, shipped it across the Great Lakes, smelted it and made steel into many different products. Companies merge with suppliers to protect themselves against losing access to supplies. Reasons for Merging Mergers take place for many reasons. Most of the reasons are to improve the company s performance in the eyes of the shareholder. Faster Growth Some companies cannot grow as fast as they would like if they only use internally generated funds. By merging with another firm, the company s size and sales appear to grow faster. Synergy This is the idea that when firms combine, they will take the best characteristics of each to become a better and stronger company. It is always tempting for management and shareholders to think that one and one make three. 3

4 Economies of Scale When firms combine, the larger size of the new company can lead to lower costs in manufacturing, sales, or some other part of a business. For example, two banks that merge can close some branch locations that once competed with each other. Diversification Some firms merge because they want to get new product lines. When a telecommunications company such as AT&T buys a cable TV company, it can offer faster Internet access and telephone service in a single package. Elimination of Rivals Sometimes firms merge to catch up with, or even remove, rivals. Royal Caribbean Cruises acquired Celebrity Cruise Lines in a horizontal merger to double in size. It became the second-largest cruise line behind Carnival. Change or Lose Corporate Identity A merger may help a company change or lose a corporate identity. For example, ValuJet merged with AirWays to form AirTran Holdings Corporation, hoping the name change would help the public forget ValuJet s tragic Everglades crash in 1996 that took 110 lives. The new company flew the same planes and routes as the original one. Instead of merging, a company may simply buy another company. A merger usually includes an exchange of stock. In an acquisition or a buyout, the purchasing firm uses its own cash or stock. Exploring the Essential Question Research a horizontal merger that occurred in the last three years in the United States. Using reliable sources for facts, write two paragraphs describing the merger and the reasons for the horizontal merger. What benefits are expected from the merger? Conglomerates A corporation may become so large through mergers and acquisitions that it turns into a conglomerate. A conglomerate is a firm that typically has at least four businesses. And each of the four businesses makes unrelated products. None of the businesses is responsible for a majority of its sales. For example, the largest of 3M Company s six business segments in Figure 8.6 produces about one-third of its sales. Diversification is one of the main reasons for conglomerate mergers. Some firms hope to protect their overall sales and profits by not putting all their eggs in one basket. Isolated economic events, such as bad weather or a sudden change of consumer tastes, may affect some product lines but not all of them at the same time. In recent years, the number of conglomerates in the United States has dropped. But in Asia, conglomerates remain strong. Samsung, LG, and Hyundai-Kia still lead in South Korea. Strong conglomerates in Japan include Mitsubishi, Panasonic, and Sony. Multinationals Other large corporations have become international in scope. A multinational is a corporation that has manufacturing or service operations in a number of different countries. In effect, it is a citizen of several countries at one time. A multinational is likely to pay taxes in each country where it has 4

5 operations. It also must follow the laws of each. General Motors, Nabisco, British Petroleum, Royal Dutch Shell, Mitsubishi, and Sony are examples of multinational corporations that have achieved worldwide economic importance. Multinational corporations are important because they can move resources, goods, services, and financial capital across national borders. A multinational with headquarters in Canada could sell bonds in France. It could then use the proceeds to expand a plant in Mexico that makes products for sale in the United States. A multinational may also be a conglomerate if it makes unrelated products. Many countries welcome multinationals because they bring new technologies and generate jobs in areas where jobs are needed. Multinationals also produce tax revenues for host countries, which helps their economies. At times, multinationals have abused their power by paying low wages to workers. They might also export scarce natural resources or interfere with local business development. Some critics say that multinational corporations can demand tax, regulatory, and wage breaks by threatening to move to another country. Other critics are concerned that multinationals may change traditional ways of life and business customs in a host country. But most economists welcome the lower-cost production and higher-quality output that global competition brings. They also believe that the transfer of technology that eventually takes place will raise the standard of living for everyone. Overall, the advantages of multinationals far outweigh the disadvantages. Reading Progress Check Explaining What are the different types of mergers that happen within businesses? Entrepreneurial Funding for Start-ups Guiding Question What are the different ways businesses can find start-up funds? Businesses are so important to the health of regions and countries that people don t always wait for businesses to grow. Instead, states, colleges and universities, and private investors may step in to fund expansion more quickly. Entrepreneurial Education and Incubators The hardest part about starting a new business isn t always finding a good idea. Instead, the problem is often getting the money and management team to put the idea into action. To fill this need, many states and universities have begun to support start-up incubators, where would-be entrepreneurs are trained in accounting, engineering, and managerial skills. They may also get financing to give life to a business idea. Many universities even have specialized post-college curriculums that lead to a degree in entrepreneurship. At the end of the program, students may compete for start-up funds from either the 5

6 state or private investors. They may never become successful entrepreneurs, of course, but without these programs they might not have had a chance to try. Historically, top universities and companies have worked together on research projects that could enrich both sides. Incubators, however, reach a much broader range of people than the researchers who previously benefited from these agreements and may have done little or no teaching. Venture Capitalists A venture capitalist is someone who lends investment funds to a new or unproven business in exchange for an equity (ownership) share. Venture capitalists are often well known in the start-up community. New businesses usually must give a rigorous presentation to get funding. In return, the venture capitalist may expect as much as a 25 percent annual return on his or her investment, and require ownership of at least half the company. These terms may seem severe, but they offset expected losses on other investments that the venture capitalist makes. The venture capitalist will also offer helpful knowledge to the start-up. He or she can also introduce the entrepreneur to other firms in the industry to help solve problems. The venture capitalist will help the entrepreneur with an initial public offering (IPO) of stock in hopes of getting a high price. If the IPO is successful, the venture capitalist might sell his or her shares and then go look for another startup to fund. Angel Investors Angel investors are usually small investors who like to fund the start-ups of family, friends, or others whose business ideas have potential. Angel investors provide seed money that those start-ups could not otherwise get. We use the term angel because these investors are usually more interested in helping the individual survive than getting a substantial return on their investment. Their terms are much more generous and forgiving than the terms of any other type of funding. While there is no set pattern or model for angel lending, support is usually in the form of a onetime injection of funds, although even that might change over time. Some angel investors organize into clubs and join their funds. Others organize more formally and require a piece of the business if it is successful. Wealthy investors in some communities treat angel investing almost like a hobby or civic duty, such as funding art and museums. Crowdfunding One of the newest ways for an entrepreneur to get financing is through crowdfunding, also known as crowdsourcing, making an appeal to a crowd of possibly interested investors on a social networking platform. This approach is inexpensive. All that is required is a good idea, a successful crowdfunding strategy, a proper media platform, and a crowd willing to listen and, of course, contribute. Crowdfunding had its roots in Facebook and LinkedIn, when people began asking for advice from individuals or groups. The earliest crowdfunding sites, such as Kickstarter, Fundable, and Crowdfunder, have had different degrees of success. But they are still changing as technology changes. Until then, one of the success stories that every crowdfunding entrepreneur would love to match is the $5.7 million raised on Kickstarter in a little more than 10 hours, when more than 90,000 sponsors contributed to bring the fan-favorite movie Veronica Mars back to life on the big screen. 6

7 Reading Progress Check Explaining What are the advantages and disadvantages of seeking financial start-up from a venture capitalist? 7