Business Growth and Expansion
When Hansen Natural decided to sign up a celebrity to endorse its
products, the company hoped to increase profits by expanding its markets
and sales. Investing these profits in new plant, equipment, and products is
one way a business can grow. Another way a business can expand is by
engaging in a merger—a combination of two or more businesses to form a
single firm. Yet mergers can be risky because they often combine very
different corporate cultures, and there is no guarantee that consumers will
like the resulting products. Even so, the payoffs can be huge, so the
temptation to merge is always attractive to businesses.
Growth Through Reinvestment
Most businesses use financial statements to keep track of their
business operations. One of the most important of those is the income
statement—a report showing a business’s sales, expenses, net income, and
cash flows for a period of time, such as three months or a year. We can use
the income statement to show how a business can use some of the revenue
it receives from sales to grow through reinvestment.
Estimating Cash Flow
An income statement such as shows a firm’s net income—the funds left
over after all of the firm’s expenses, including taxes, are subtracted from its
sales. These 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 of these payments
is depreciation—a noncash charge the firm takes for the general wear and
tear on its capital goods. Depreciation is called a noncash charge because
the money stays in the firm rather than being paid to someone else. For
example, interest may be paid to a bank, wages may be paid to employees,
or payments may be made to suppliers to provide some of the inputs used
in production. However, the money allocated to depreciation never goes
anywhere. Since this money stays in the business, the firm treats it as a form
of income. Because of this, firms usually prefer to take as much depreciation
as possible. As you can see in the figure, an incease in depreciation would
lower the earnings before tax but increase the cash flow. The cash flow—the
sum of net income and noncash charges, such as depreciation—is the
bottom line, a more comprehensive measure of profits. This is because the
cash flow represents the total amount of new funds generated from
operations.
Reinvesting Cash Flow
If the business has a positive cash flow, the owners can then decide
how to allocate it. The board of directors of a corporation may declare a
dividend to be paid directly to shareholders as a reward for their
investments. The owners of a proprietorship or partnership may keep some
cash flow as the reward for risk-taking. The remainder of the funds could
then be reinvested in new plant, equipment, or technologies. When cash
flows are reinvested in the business, the firm can produce additional
products. This generates additional sales and an even larger cash flow
during the next sales period. As long as the firm has positive cash flows, and
as long as the reinvested funds are larger than the wear and tear on
equipment, the firm will grow. Finally, the concept of cash flow is also
important to investors. In fact, if investors want to know about the financial
health of a firm, a positive cash flow is one of the first things they look for.
Growth Through Mergers
When two companies merge, one gives up its separate legal identity. For
public recognition purposes, however, the name of the new company may
reflect the identities of both. When Chase National Bank and Bank of
Manhattan merged, the new company was called the Chase Manhattan
Bank of New York. Later it changed its name to the Chase Manhattan
Corporation to reflect its geographically expanding business. Finally, after
merging with JP Morgan, it settled on JPMorgan Chase. Likewise, Procter &
Gamble kept the brand name Gillette after it bought the company.
Types of Mergers
When companies involved in different stages of manufacturing or
marketing join together, it results in a vertical merger. One example of a
vertical merger is the formation of the U.S. Steel Corporation. At one time it
mined its own ore, shipped it across the Great Lakes, smelted it, and made
steel into many different products. Vertical mergers take place when
companies seek to protect against the potential loss of suppliers.
Reasons for Merging
Mergers take place for a variety of reasons. A business may seek a
merger to grow faster, to become more efficient, to acquire or deliver a better
product, to eliminate a rival, or to change its image. For example, some
managers find that they cannot grow as fast as they would like using the
funds they generate internally. As a result, one firm may consider merging
with another firm. Sometimes a merger makes sense, and other times it may
not, but the desire to become a larger company in the industry—if not the
largest—is one reason that mergers take place.
Efficiency is another reason for mergers. When two firms merge, they
no longer need two presidents, two treasurers, and two personnel directors.
The new company can have more retail outlets or manufacturing capabilities
without significantly increasing management costs. In addition, the new
company may be able to get better discounts by making volume purchases,
and it may be able to make more effective use of its advertising. Sometimes
the merging firms can achieve two objectives at once—such as dominant
size and improved efficiency.
Some mergers are driven by the desire to acquire new product lines.
When a telecommunications company such as AT&T buys a cable TV
company, for example, it can offer faster Internet access and telephone
service in a single package. Sometimes firms merge to catch up with, or even
eliminate, rivals. Royal Caribbean Cruises acquired Celebrity Cruise Lines
and nearly doubled in size to become the second largest cruise line behind
Carnival. Finally, a company may use a merger to lose its corporate identity.
For example, ValuJet merged with AirWays to form AirTran Holdings
Corporation. The new company flew the same planes and routes as the
original company, but AirTran hoped the name change would help the public
forget ValuJet’s tragic Everglades crash in 1996 that claimed 110 lives.
Conglomerates
A corporation may become so large through mergers and acquisitions
that it turns into a conglomerate. A conglomerate is a firm that has at least
four businesses, each making unrelated products and none responsible for
a majority 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 declined. In
Asia, however, conglomerates remain strong. Samsung, Gold Star, and
Daewoo are still dominant in Korea, as are Mitsubishi, Panasonic, and Sony
in Japan.
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
operations and is subject to the laws of each. General Motors, Nabisco,
British Petroleum, Royal Dutch Shell, Mitsubishi, and Sony are examples of
multinational corporations that have attained worldwide economic
importance. Multinational corporations are important because they have
the ability to move resources, goods, services, and financial capital across
national borders. A multinational with its headquarters in Canada, for
example, could sell bonds in France. The proceeds could then be used 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,
but it is more likely to be called a multinational if it conducts operations in
several different countries.
Multinationals are usually welcome in a nation because they transfer
new technology and generate new jobs in areas where jobs are needed.
Multinationals also produce tax revenues for the host country, which helps
that nation’s economy. At times, multinationals have been known to abuse
their power by paying low wages to workers, exporting scarce natural
resources, or interfering with the development of local businesses. Some
critics point out that multinational corporations are able to demand tax,
regulatory, and wage concessions by threatening to move their operations to
another country. Other critics are concerned that multinationals may alter
traditional ways of life and business customs in the host country. Most
economists, however, 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. On balance, the advantages of multinationals far
outweigh the disadvantages.
