Arthur j keown financial management pdf

Analyzing Financial Performance

The equity section of the balance sheet can include many items such as preferred stock, common stock par value, additional paid-in capital, retained earnings, and treasury stock. Elaborate on why these items are important for investors, what the items reflect, and what they have to do with the market price of the firm’s shares of stock.

Search on the Internet for an academic or industry-related article regarding this thesis and its implications for Saudi Arabia and Saudi Vision 2030.

For your discussion post, your first step is to summarize the article in two paragraphs, describing what you think are the most important points made by the authors (remember to use citations where appropriate). For the second step, include the reference listing with a hyperlink to the article. Do not copy the article into your post and limit your summary to two paragraphs.

This week’s Discussion Question asks you to elaborate on the equity section of the balance sheet and elaborate on why these items are important for investors, what the items reflect, and what they have to do with the market price of the firm’s shares of stock. Be sure to support your statements with logic and argument, citing any sources referenced. Post your initial response early and check back often to continue the discussion

The Logic and Practice of Financial Management

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Foundations of Finance

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The Logic and Practice of Financial Management

Ninth Edition

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Foundations of Finance

Arthur J. Keown Virginia Polytechnic Institute and State University

R. B. Pamplin Professor of Finance

John D. Martin Baylor University

Professor of Finance Carr P. Collins Chair in Finance

J. William Petty Baylor University

Professor of Finance W. W. Caruth Chair in Entrepreneurship

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Library of Congress Cataloging-in-Publication Data

Names: Keown, Arthur J. | Martin, John D. | Petty, J. William Title: Foundations of finance: the logic and practice of financial

management/Arthur J. Keown, John D. Martin, J. William Petty. Description: Ninth Edition. | Boston : Pearson, 2016. | Series: The pearson series in finance | Revised edition of Foundations of finance, 2014.

| Includes bibliographical references and index. Identifiers: LCCN 2015039822| ISBN 9780134083285 (alk. paper) | ISBN 0134083288 (alk. paper) Subjects: LCSH: Corporations–Finance. Classification: LCC HG4026.F67 2016 | DDC 658.15–dc23 LC record available at http://lccn.loc.gov/2015039822

ISBN 10: 0-13-408328-8 ISBN 13: 978-0-13-408328-5

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To my parents, from whom I learned the most. Arthur J. Keown

To the Martin women—wife Sally and daughter-in-law Mel, the Martin men—sons Dave and Jess, and the Martin boys—grandsons

Luke and Burke. John D. Martin

To Jack Griggs, who has been a most loyal and dedicated friend for over 55 years, always placing my interests above his own, and made

life’s journey a lot of fun along the way. J. William Petty

vi

Arthur J. Keown is the Department Head and R. B. Pamplin Professor of Finance at Virginia Polytechnic Institute and State University. He received his bachelor’s degree from Ohio Wesleyan University, his M.B.A. from the University of Michigan, and his doctorate from Indiana University. An award-winning teacher, he is a member of the Academy of Teaching Excellence; has received five Certificates of Teaching Excellence at Virginia Tech, the W. E. Wine Award for Teaching Excellence, and the Alumni Teaching Excellence Award; and in 1999 received the Outstanding Faculty Award from the State of Virginia. Professor Keown is widely published in academic journals. His work has appeared in the Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analysis, Journal of Financial Research, Journal of Banking and Finance, Financial Management, Journal of Portfolio Management, and many others. In addition to Foundations of Finance, two others of his books are widely used in college finance classes all over the country—Basic Financial Management and Personal Finance: Turning Money into Wealth. Professor Keown is a Fellow of the Decision Sciences Institute, was a member of the Board of Directors of the Financial Management Association, and is the head of the finance department at Virginia Tech. In addition, he served as the co-editor of the Journal of Financial Research for 6½ years and as the co-editor of the Financial Management Association’s Survey and Synthesis series for 6 years. He lives with his wife in Blacksburg, Virginia, where he collects original art from Mad Magazine.

John D. Martin holds the Carr P. Collins Chair in Finance in the Hankamer School of Business at Baylor University, where he was selected as the outstanding professor in the EMBA program multiple times. Professor Martin joined the Baylor faculty in 1998 after spending 17 years on the faculty of the University of Texas at Austin. Over his career he has published over 50 articles in the leading finance jour- nals, including papers in the Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analysis, Journal of Monetary Economics, and Management Science. His recent research has spanned issues related to the economics of uncon- ventional energy sources, the hidden cost of venture capital, and the valuation of firms filing Chapter 11. He is also co-author of several books, including Financial Management: Principles and Practice (13th ed., Prentice Hall), Foundations of Finance (9th ed., Prentice Hall), Theory of Finance (Dryden Press), Financial Analysis (3rd ed., McGraw-Hill), Valuation: The Art and Science of Corporate Investment Decisions (3rd ed., Prentice Hall), and Value Based Management with Social Responsibility (2nd ed., Oxford University Press).

About the Authors

vii

J. William Petty, PhD, Baylor University, is Professor of Finance and W. W. Caruth Chair of Entrepreneurship. Dr. Petty teaches entrepreneurial finance at both the undergraduate and graduate levels. He is a University Master Teacher. In 2008, the Acton Foundation for Entrepreneurship Excellence selected him as the National Entrepreneurship Teacher of the Year. His research interests include the financing of entrepreneurial firms and shareholder value-based management. He has served as the co-editor for the Journal of Financial Research and the editor of the Journal of Entrepreneurial Finance. He has published articles in various academic and professional journals, including Journal of Financial and Quantitative Analysis, Financial Management, Journal of Portfolio Management, Journal of Applied Corporate Finance, and Accounting Review. Dr. Petty is co-author of a leading textbook in small business and entrepreneurship, Small Business Management: Launching and Growing Entrepreneurial Ventures. He also co-authored Value-Based Management: Corporate America’s Response to the Shareholder Revolution (2010). He serves on the Board of Directors of a publicly traded oil and gas firm. Finally, he serves on the Board of the Baylor Angel Network, a network of private investors who provide capital to start-ups and early-stage companies.

viii

Preface xvii

PART 1 The Scope and Environment of Financial Management 2

1 An Introduction to the Foundations of Financial Management 2 2 The Financial Markets and Interest Rates 22 3 Understanding Financial Statements and Cash Flows 54 4 Evaluating a Firm’s Financial Performance 106

PART 2 The Valuation of Financial Assets 152 5 The Time Value of Money 152 6 The Meaning and Measurement of Risk and Return 196 7 The Valuation and Characteristics of Bonds 236 8 The Valuation and Characteristics of Stock 268 9 The Cost of Capital 294

PART 3 Investment in Long-Term Assets 326 10 Capital-Budgeting Techniques and Practice 326 11 Cash Flows and Other Topics in Capital Budgeting 368

PART 4 Capital Structure and Dividend Policy 406 12 Determining the Financing Mix 406 13 Dividend Policy and Internal Financing 444

PART 5 Working-Capital Management and International Business Finance 466

14 Short-Term Financial Planning 466 15 Working-Capital Management 486 16 International Business Finance 514

Web 17 Cash, Receivables, and Inventory Management Available online at www.myfinancelab.com Web Appendix A Using a Calculator Available online at www.myfinancelab.com

Glossary 536 Indexes 545

Brief Contents

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Contents Preface xvii

PART 1 The Scope and Environment of Financial Management 2

1 An Introduction to the Foundations of Financial Management 2 The Goal of the Firm 3

Five Principles That Form the Foundations of Finance 4 Principle 1: Cash Flow Is What Matters 4 Principle 2: Money Has a Time Value 5 Principle 3: Risk Requires a Reward 5 Principle 4: Market Prices Are Generally Right 6 Principle 5: Conflicts of Interest Cause Agency Problems 8 The Global Financial Crisis 9 Avoiding Financial Crisis—Back to the Principles 10 The Essential Elements of Ethics and Trust 11

The Role of Finance in Business 12 Why Study Finance? 12 The Role of the Financial Manager 13

The Legal Forms of Business Organization 14 Sole Proprietorships 14 Partnerships 14 Corporations 15 Organizational Form and Taxes: The Double Taxation on Dividends 15 S-Corporations and Limited Liability Companies (LLCs) 16 Which Organizational Form Should Be Chosen? 16

Finance and the Multinational Firm: The New Role 17

Chapter Summaries 18 • Review Questions 20 • Mini Case 21

2 The Financial Markets and Interest Rates 22 Financing of Business: The Movement of Funds Through

the Economy 24 Public Offerings Versus Private Placements 25 Primary Markets Versus Secondary Markets 26 The Money Market Versus the Capital Market 27 Spot Markets Versus Futures Markets 27 Stock Exchanges: Organized Security Exchanges Versus Over-the-Counter

Markets, a Blurring Difference 27

Selling Securities to the Public 29 Functions 29 Distribution Methods 30 Private Debt Placements 31 Flotation Costs 33 Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley

Act 33

Rates of Return in the Financial Markets 34 Rates of Return over Long Periods 34 Interest Rate Levels in Recent Periods 35

Interest Rate Determinants in a Nutshell 38 Estimating Specific Interest Rates Using Risk Premiums 38 Real Risk-Free Interest Rate and the Risk-Free Interest Rate 39 Real and Nominal Rates of Interest 39 Inflation and Real Rates of Return: The Financial Analyst’s Approach 41 The Term Structure of Interest Rates 43 Shifts in the Term Structures of Interest Rates 43 What Explains the Shape of the Term Structure? 45

Chapter Summaries 47 • Review Questions 50 • Study Problems 50 • Mini Case 53

3 Understanding Financial Statements and Cash Flows 54 The Income Statement 56

Coca-Cola’s Income Statement 58 Restating Coca-Cola’s Income Statement 59

The Balance Sheet 61 Types of Assets 61 Types of Financing 63 Coca-Cola’s Balance Sheet 65 Working Capital 66

Measuring Cash Flows 69 Profits Versus Cash Flows 69 The Beginning Point: Knowing When a Change in the Balance Sheet Is a Source

or Use of Cash 71 Statement of Cash Flows 71 Concluding Suggestions for Computing Cash Flows 78 What Have We Learned about Coca-Cola? 79

GAAP and IFRS 79

Income Taxes and Finance 80 Computing Taxable Income 80 Computing the Taxes Owed 81

The Limitations of Financial Statements and Accounting Malpractice 83

Chapter Summaries 85 • Review Questions 88 • Study Problems 89 • Mini Case 97

Appendix 3A: Free Cash Flows 100 Computing Free Cash Flows 100

Computing Financing Cash Flows 105

Study Problems 104

4 Evaluating a Firm’s Financial Performance 106 The Purpose of Financial Analysis 106

Measuring Key Financial Relationships 110 Question 1: How Liquid Is the Firm—Can It Pay Its Bills? 111 Question 2: Are the Firm’s Managers Generating Adequate Operating Profits

on the Company’s Assets? 116 Managing Operations 118 Managing Assets 119 Question 3: How Is the Firm Financing Its Assets? 123 Question 4: Are the Firm’s Managers Providing a Good Return on the Capital

Provided by the Company’s Shareholders? 126 Question 5: Are the Firm’s Managers Creating Shareholder Value? 131

x Contents

Contents xi

The Limitations of Financial Ratio Analysis 138

Chapter Summaries 139 • Review Questions 142 • Study Problems 142 • Mini Case 150

PART 2 The Valuation of Financial Assets 152

5 The Time Value of Money 152 Compound Interest, Future Value, and Present Value 154

Using Timelines to Visualize Cash Flows 154 Techniques for Moving Money Through Time 157 Two Additional Types of Time Value of Money Problems 162 Applying Compounding to Things Other Than Money 163 Present Value 164

Annuities 168 Compound Annuities 168 The Present Value of an Annuity 170 Annuities Due 172 Amortized Loans 173

Making Interest Rates Comparable 175 Calculating the Interest Rate and Converting It to an EAR 177 Finding Present and Future Values With Nonannual Periods 178 Amortized Loans With Monthly Compounding 181

The Present Value of an Uneven Stream and Perpetuities 182 Perpetuities 183

Chapter Summaries 184 • Review Questions 187 • Study Problems 187 • Mini Case 195

6 The Meaning and Measurement of Risk and Return 196 Expected Return Defined and Measured 198

Risk Defined and Measured 201

Rates of Return: The Investor’s Experience 208

Risk and Diversification 209 Diversifying Away the Risk 210 Measuring Market Risk 211 Measuring a Portfolio’s Beta 218 Risk and Diversification Demonstrated 219

The Investor’s Required Rate of Return 222 The Required Rate of Return Concept 222 Measuring the Required Rate of Return 222

Chapter Summaries 225 • Review Questions 229 • Study Problems 229 • Mini Case 234

7 The Valuation and Characteristics of Bonds 236 Types of Bonds 237

Debentures 237 Subordinated Debentures 238 Mortgage Bonds 238 Eurobonds 238 Convertible Bonds 238

xii Contents

Terminology and Characteristics of Bonds 239 Claims on Assets and Income 239 Par Value 239 Coupon Interest Rate 240 Maturity 240 Call Provision 240 Indenture 240 Bond Ratings 241

Defining Value 242

What Determines Value? 244

Valuation: The Basic Process 245

Valuing Bonds 246

Bond Yields 252 Yield to Maturity 252 Current Yield 254

Bond Valuation: Three Important Relationships 255

Chapter Summaries 260 • Review Questions 263 • Study Problems 264 • Mini Case 267

8 The Valuation and Characteristics of Stock 268 Preferred Stock 269

The Characteristics of Preferred Stock 270

Valuing Preferred Stock 271

Common Stock 275 The Characteristics of Common Stock 275

Valuing Common Stock 277

The Expected Rate of Return of Stockholders 282 The Expected Rate of Return of Preferred Stockholders 283 The Expected Rate of Return of Common Stockholders 284

Chapter Summaries 287 • Review Questions 290 • Study Problems 290 • Mini Case 293

9 The Cost of Capital 294 The Cost of Capital: Key Definitions and Concepts 295

Opportunity Costs, Required Rates of Return, and the Cost of Capital 295

The Firm’s Financial Policy and the Cost of Capital 296

Determining the Costs of the Individual Sources of Capital 297 The Cost of Debt 297 The Cost of Preferred Stock 299 The Cost of Common Equity 301 The Dividend Growth Model 302 Issues in Implementing the Dividend Growth Model 303 The Capital Asset Pricing Model 304 Issues in Implementing the CAPM 305

The Weighted Average Cost of Capital 307 Capital Structure Weights 308 Calculating the Weighted Average Cost of Capital 308

Contents xiii

Calculating Divisional Costs of Capital 311 Estimating Divisional Costs of Capital 311 Using Pure Play Firms to Estimate Divisional WACCs 311 Using a Firm’s Cost of Capital to Evaluate New Capital Investments 313

Chapter Summaries 317 • Review Questions 319 • Study Problems 320 • Mini Cases 324

PART 3 Investment in Long-Term Assets 326

10 Capital-Budgeting Techniques and Practice 326 Finding Profitable Projects 327

Capital-Budgeting Decision Criteria 328 The Payback Period 328 The Net Present Value 332 Using Spreadsheets to Calculate the Net Present Value 335 The Profitability Index (Benefit–Cost Ratio) 335 The Internal Rate of Return 338 Computing the IRR for Uneven Cash Flows with a Financial Calculator 340 Viewing the NPV–IRR Relationship: The Net Present Value Profile 341 Complications with the IRR: Multiple Rates of Return 343 The Modified Internal Rate of Return (MIRR) 344 Using Spreadsheets to Calculate the MIRR 347 A Last Word on the MIRR 347

Capital Rationing 348 The Rationale for Capital Rationing 349 Capital Rationing and Project Selection 349

Ranking Mutually Exclusive Projects 350 The Size-Disparity Problem 350 The Time-Disparity Problem 351 The Unequal-Lives Problem 352

Chapter Summaries 356 • Review Questions 359 • Study Problems 359 • Mini Case 366

11 Cash Flows and Other Topics in Capital Budgeting 368 Guidelines for Capital Budgeting 369

Use Free Cash Flows Rather Than Accounting Profits 369 Think Incrementally 369 Beware of Cash Flows Diverted from Existing Products 370 Look for Incidental or Synergistic Effects 370 Work in Working-Capital Requirements 370 Consider Incremental Expenses 371 Remember That Sunk Costs Are Not Incremental Cash Flows 371 Account for Opportunity Costs 371 Decide If Overhead Costs Are Truly Incremental Cash Flows 371 Ignore Interest Payments and Financing Flows 372

Calculating a Project’s Free Cash Flows 372 What Goes into the Initial Outlay 372 What Goes into the Annual Free Cash Flows over the Project’s Life 373 What Goes into the Terminal Cash Flow 375 Calculating the Free Cash Flows 375 A Comprehensive Example: Calculating Free Cash Flows 379

Options in Capital Budgeting 382 The Option to Delay a Project 383 The Option to Expand a Project 383 The Option to Abandon a Project 384 Options in Capital Budgeting: The Bottom Line 384

xiv Contents

Risk and the Investment Decision 385 What Measure of Risk Is Relevant in Capital Budgeting? 386 Measuring Risk for Capital-Budgeting Purposes with a Dose of Reality—Is

Systematic Risk All There Is? 387 Incorporating Risk into Capital Budgeting 387 Risk-Adjusted Discount Rates 387 Measuring a Project’s Systematic Risk 390 Using Accounting Data to Estimate a Project’s Beta 391 The Pure Play Method for Estimating Beta 391 Examining a Project’s Risk Through Simulation 391 Conducting a Sensitivity Analysis Through Simulation 393

Chapter Summaries 394 • Review Questions 396 • Study Problems 396 • Mini Case 402

Appendix 11A: The Modified Accelerated Cost Recovery System 404 What Does All This Mean? 405

Study Problems 405

PART 4 Capital Structure and Dividend Policy 406

12 Determining the Financing Mix 406 Understanding the Difference Between Business and Financial

Risk 408 Business Risk 409 Operating Risk 409

Break-Even Analysis 409 Essential Elements of the Break-Even Model 410 Finding the Break-Even Point 412 The Break-Even Point in Sales Dollars 413

Sources of Operating Leverage 414 Financial Leverage 416 Combining Operating and Financial Leverage 418

Capital Structure Theory 420 A Quick Look at Capital Structure Theory 422 The Importance of Capital Structure 422 Independence Position 422 The Moderate Position 424 Firm Value and Agency Costs 426 Agency Costs, Free Cash Flow, and Capital Structure 428 Managerial Implications 428

The Basic Tools of Capital Structure Management 429 EBIT-EPS Analysis 429 Comparative Leverage Ratios 432 Industry Norms 433 Net Debt and Balance-Sheet Leverage Ratios 433 A Glance at Actual Capital Structure Management 433

Chapter Summaries 436 • Review Questions 439 • Study Problems 439 • Mini Cases 442

13 Dividend Policy and Internal Financing 444 Key Terms 445

Does Dividend Policy Matter to Stockholders? 446 Three Basic Views 446 Making Sense of Dividend Policy Theory 449 What Are We to Conclude? 451

Contents xv

The Dividend Decision in Practice 452 Legal Restrictions 452 Liquidity Constraints 452 Earnings Predictability 453 Maintaining Ownership Control 453 Alternative Dividend Policies 453 Dividend Payment Procedures 453

Stock Dividends and Stock Splits 454

Stock Repurchases 455 A Share Repurchase as a Dividend Decision 456 The Investor’s Choice 457 A Financing or an Investment Decision? 458 Practical Considerations—The Stock Repurchase Procedure 458

Chapter Summaries 459 • Review Questions 461 • Study Problems 462 • Mini Case 465

PART 5 Working-Capital Management and International Business Finance 466

14 Short-Term Financial Planning 466 Financial Forecasting 467

The Sales Forecast 467 Forecasting Financial Variables 467 The Percent of Sales Method of Financial Forecasting 468 Analyzing the Effects of Profitability and Dividend Policy

on DFN 469 Analyzing the Effects of Sales Growth on a Firm’s DFN 470

Limitations of the Percent of Sales Forecasting Method 473

Constructing and Using a Cash Budget 474 Budget Functions 474 The Cash Budget 475

Chapter Summaries 477 • Review Questions 478 • Study Problems 479 • Mini Case 484

15 Working-Capital Management 486 Managing Current Assets and Liabilities 487

The Risk–Return Trade-Off 488 The Advantages of Current versus Long-term Liabilities: Return 488 The Disadvantages of Current versus Long-term Liabilities: Risk 488

Determining the Appropriate Level of Working Capital 489 The Hedging Principle 489 Permanent and Temporary Assets 490 Temporary, Permanent, and Spontaneous Sources of Financing 490 The Hedging Principle: A Graphic Illustration 491

The Cash Conversion Cycle 492

Estimating the Cost of Short-Term Credit Using the Approximate Cost-of-Credit Formula 494

Sources of Short-Term Credit 496 Unsecured Sources: Accrued Wages and Taxes 497 Unsecured Sources: Trade Credit 498 Unsecured Sources: Bank Credit 499 Unsecured Sources: Commercial Paper 501

xvi Contents

Secured Sources: Accounts-Receivable Loans 503 Secured Sources: Inventory Loans 505

Chapter Summaries 506 • Review Questions 509 • Study Problems 510

16 International Business Finance 514 The Globalization of Product and Financial Markets 515

Foreign Exchange Markets and Currency Exchange Rates 516 Foreign Exchange Rates 517 What a Change in the Exchange Rate Means for Business 517 Exchange Rates and Arbitrage 520 Asked and Bid Rates 520 Cross Rates 520 Types of Foreign Exchange Transactions 522 Exchange Rate Risk 524

Interest Rate Parity 526

Purchasing-Power Parity and the Law of One Price 527 The International Fisher Effect 528

Capital Budgeting for Direct Foreign Investment 528 Foreign Investment Risks 529

Chapter Summaries 530 • Review Questions 532 • Study Problems 533 • Mini Case 534

Web 17 Cash, Receivables, and Inventory Management Available online at www.myfinancelab.com

Web Appendix A Using a Calculator Available online at www.myfinancelab.com

Glossary 536

Indexes 545

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The study of finance focuses on making decisions that enhance the value of the firm. This is done by providing customers with the best products and services in a cost- effective way. In a sense we, the authors of Foundations of Finance, share the same purpose. We have tried to create a product that provides value to our customers— both students and instructors who use the text. It was this priority that led us to write Foundations of Finance: The Logic and Practice of Financial Management, which was the first “shortened book” of financial management when it was first published. This text launched a trend that has since been followed by all the major competing texts in this market. The text broke new ground not only by reducing the breadth of mate- rials covered but also by employing a more intuitive approach to presenting new material. From that first edition, the text has met with success beyond our expecta- tions for eight editions. For that success, we are eternally grateful to the multitude of finance instructors who have chosen to use the text in their classrooms.

New to the Ninth Edition Technology is ever present in our lives today, and we are beginning to see its effec- tive use in education. One form of learning technology that we believe has great merit today is the lecture video. For all the numbered in-text examples in the Ninth Edition, we have recorded brief (10- to 15-minute) lecture videos that students can replay as many times as they need to help them understand more fully each of the in-text examples. We are confident that many students will enjoy having the authors “tutoring” them when it comes to the primary examples in the text. The videos can be found in the eText within MyFinanceLab.

In addition to the innovations of this edition, we have made some chapter-by- chapter updates in response to the continued development of financial thought, reviewer comments, and the recent economic crisis. Some of these changes include:

Chapter 1 An Introduction to the Foundations of Financial Management

◆ Revised and updated chapter introduction ◆ Revised and updated discussion of the five principles

Chapter 2 The Financial Markets and Interest Rates

◆ Revised coverage of the term structure of interest rates to address the very low rates that characterize today’s markets

◆ Simplified, more intuitive discussion on interest rate determinants ◆ Added coverage of the term structure of interest rates into the end-of-chapter

problems

Chapter 3 Understanding Financial Statements and Cash Flows

◆ Uses The Coca-Cola Company, a firm all students are familiar with, to help them understand financial statements

◆ Expanded coverage of balance sheets, focusing on what can be learned from them

Preface

xviii Preface

◆ More intuitive presentation of cash flows ◆ New explanation of fixed and variable costs as part of presenting an income

statement ◆ Four lecture videos accompany the in-chapter examples.

Chapter 4 Evaluating a Firm’s Financial Performance

◆ Continues the use of The Coca-Cola Company’s financial data to illustrate how we evaluate a firm’s financial performance, compared to industry norms or a peer group. In this case, we compare Coca-Cola’s financial performance to that of PepsiCo, a major competitor.

◆ Provides a new Finance at Work box, based on an example from the soft-drink industry

◆ Revised presentation of evaluating a company’s liquidity to align more closely with how business managers talk about liquidity

◆ Four lecture videos accompany the in-chapter examples.

Chapter 5 The Time Value of Money

◆ Revised to appeal to all students regardless of their level of mathematical skill ◆ New section added on “Making Interest Rates Comparable,” with new end-of-

chapter questions dealing with calculation of the effective annual rate ◆ Additional problems emphasizing complex streams of cash flows ◆ Thirteen lecture videos accompany the in-chapter examples.

Chapter 6 The Meaning and Measurement of Risk and Return

◆ Updated information on the rates of return that investors have earned over the long term with different types of security investments

◆ Numerous new examples involving companies the students are familiar with are presented throughout the chapter to illustrate the concepts and applications in the chapter.

◆ Two lecture videos accompany the in-chapter examples.

Chapter 7 The Valuation and Characteristics of Bonds

◆ A number of new examples involving real-life firms ◆ Two lecture videos accompany the in-chapter examples.

Chapter 8 The Valuation and Characteristics of Stock

◆ More current explanation of options for getting stock quotes from the Wall Street Journal

◆ Four lecture videos accompany the in-chapter examples.

Chapter 9 The Cost of Capital

◆ Five lecture videos correspond to the five major in-chapter examples ◆ Eight end-of-chapter problems revised or replaced by new problem exercises

Preface xix

Chapter 10 Capital-Budgeting Techniques and Practice

◆ Extensively revised chapter introduction, which looks at Disney’s decision to build the Shanghai Disney Resort

◆ Addition of a new section along with additional discussion of the modified inter- nal rate of return that not only summarizes the tool, but also provides important caveats concerning its use

◆ Eight lecture videos accompany the in-chapter examples.

Chapter 11 Cash Flows and Other Topics in Capital Budgeting

◆ Revised introduction examining the difficulties Toyota faced in estimating future cash flows when it introduced the Prius

◆ New Finance at Work box dealing with Disney World ◆ Problem set revised to include additional coverage of real options ◆ Three lecture videos accompany the in-chapter examples.

Chapter 12 Determining the Financing Mix

◆ Problem set revised to include two new and one revised exercise ◆ Two lecture videos accompany the in-chapter examples.

Chapter 13 Dividend Policy and Internal Financing

◆ Updated discussion of the tax code for personal tax treatment of dividends and capital gains

◆ A lecture video accompanies the in-chapter example.

Chapter 14 Short-Term Financial Planning

◆ Two new problems added ◆ Two lecture videos accompany the in-chapter examples.

Chapter 15 Working-Capital Management

◆ Four new problem exercises added ◆ Five lecture videos accompany the in-chapter examples.

Chapter 16 International Business Finance

◆ Revised extensively to reflect changes in exchange rates and global financial markets ◆ A new section titled “What a Change in the Exchange Rate Means for Business”

deals with the implications of exchange rate changes ◆ Three lecture videos accompany the in-chapter examples.

Web Chapter 17 Cash, Receivables, and Inventory Management

◆ Simplified presentation of chapter materials

Pedagogy That Works In our opinion, the success of this textbook derives from our focus on maintaining pedagogy that works. We endeavor to provide students with a conceptual understand-

ing of the financial decision-making process that includes a survey of the tools and techniques of finance. For the student, it is all too easy to lose sight of the logic that drives finance and to focus instead on memoriz- ing formulas and procedures. As a result, students have a difficult time understanding the interrela- tionships among the topics covered. Moreover, later in life, when the problems encountered do not match the textbook presentation, students may find themselves unprepared to abstract from what they have

learned. We have worked to be “good at the basics.” To achieve this goal, we have refined the book over the last eight editions to include the following features.

Building on Foundational Finance Principles Chapter 1 presents five foundational principles of finance which are the threads that bind all the topics of the book. Then throughout the text, we provide reminders of the foundational principles in “Remember Your Principles” boxes.

The five principles of finance allow us to provide an introduction to financial decision making rooted in current financial theory and in the current state of world economic conditions. What results is an introductory treatment of a discipline rather than the treatment of a series of isolated financial problems that managers encounter.

Use of an Integrated Learning System The text is organized around the learning objectives that appear at the beginning of each chapter to provide the instructor and student with an easy-to-use integrated learning system. Numbered icons identifying each objective appear next to the related material throughout the text and in the summary, allowing easy location of material related to each objective.

A Focus on Valuation Although many professors and instructors make valuation the central theme of their course, students often lose sight of this focus when reading their text. We reinforce this focus in the content and organization of our text in some very concrete ways:

◆ We build our discussion around the five finance principles that provide the foun- dation for the valuation of any investment.

◆ We introduce new topics in the context of “what is the value proposition?” and “how is the value of the enterprise affected?”

Real-World Opening Vignettes Each chapter begins with a story about a current, real-world company faced with a financial decision related to the chapter material that follows. These vignettes have

value of the firm’s stock to evaluate financial decisions. Many things affect stock prices; to attempt to identify a reaction to a particular financial decision would sim- ply be impossible, but fortunately that is unnecessary. To employ this goal, we need not consider every stock price change to be a market interpretation of the worth of our decisions. Other factors, such as changes in the economy, also affect stock prices. What we do focus on is the effect that our decision should have on the stock price if everything else were held constant. The market price of the firm’s stock reflects the value of the firm as seen by its owners and takes into account the complexities and complications of the real-world risk. As we follow this goal throughout our discus- sions, we must keep in mind one more question: Who exactly are the shareholders? The answer: Shareholders are the legal owners of the firm.

Concept Check 1. What is the goal of the firm? 2. How would you apply this goal in practice?

Five Principles That Form the Foundations of Finance To the first-time student of finance, the subject matter may seem like a collection of unrelated decision rules. This impression could not be further from the truth. In fact, our decision rules, and the logic that underlies them, spring from five simple princi- ples that do not require knowledge of finance to understand. These five principles guide the financial manager in the creation of value for the firm’s owners (the stock- holders).

As you will see, although it is not necessary to understand finance to understand these principles, it is necessary to understand these principles in order to understand finance. These principles may at first appear simple or even trivial, but they provide the driving force behind all that follows, weaving together the concepts and tech- niques presented in this text, and thereby allowing us to focus on the logic underly- ing the practice of financial management. Now let’s introduce the five principles.

Principle 1: Cash Flow Is What Matters You probably recall from your accounting classes that a company’s profits can differ dramatically from its cash flows, which we will review in Chapter 3. But for now understand that cash flows, not profits, represent money that can be spent. Consequently, it is cash flow, not profits, that determines the value of a business. For this reason when we analyze the consequences of a managerial decision, we focus on the resulting cash flows, not profits.

In the movie industry, there is a big difference between accounting profits and cash flow. Many a movie is crowned a success and brings in plenty of cash flow for the studio but doesn’t produce a profit. Even some of the most successful box office hits—Forrest Gump, Coming to America, Batman, My Big Fat Greek Wedding, and the TV series Babylon 5—realized no accounting profits at all after accounting for various movie studio costs. That’s because “Hollywood Accounting” allows for overhead costs not associated with the movie to be added on to the true cost of the movie. In fact, the movie Harry Potter and the Order of the Phoenix, which grossed almost $1 bil- lion worldwide, actually lost $167 million according to the accountants. Was Harry Potter and the Order of the Phoenix a successful movie? It certainly was—in fact, it was the 27th highest grossing film of all time. Without question, it produced cash, but it didn’t make any profits.

LO2 Understand the basic principles of finance, their importance, and the importance of ethics and trust.

1 PRINCIPLE

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xx Preface

been carefully prepared to stimulate student interest in the topic to come and can be used as a lecture tool to provoke class discussion.

A Step-by-Step Approach to Problem Solving and Analysis As anyone who has taught the core undergraduate finance course knows, students demonstrate a wide range of math comprehension and skill. Students who do not have the math skills needed to master the subject sometimes end up memorizing for- mulas rather than focusing on the analysis of business decisions using math as a tool. We address this problem in terms of both text content and pedagogy.

◆ First, we present math only as a tool to help us analyze problems, and only when necessary. We do not present math for its own sake.

◆ Second, finance is an analytical subject and requires that students be able to solve problems. To help with this process, numbered chapter examples appear throughout the book. All of these examples follow a very detailed and struc- tured three-step approach to problem solving that helps students develop their problem-solving skills:

Step 1: Formulate a Solution Strategy. For example, what is the appropriate for- mula to apply? How can a calculator or spreadsheet be used to “crunch the numbers”? Step 2: Crunch the Numbers. Here we provide a completely worked out step-by- step solution. We present first a description of the solution in prose and then a corresponding mathematical implementation. Step 3: Analyze Your Results. We end each solution with an analysis of what the solution means. This stresses the point that problem solving is about analysis and decision making. Moreover, in this step we emphasize that decisions are often based on incomplete information, which requires the exercise of managerial judgment, a fact of life that is often learned on the job.

“Can You Do It?” and “Did You Get It?” The text provides examples for the students to work at the conclusion of each major section of a chapter, which we call “Can You Do It?,” fol- lowed by “Did You Get It?” later in the chapter. This tool provides an essential ingredient in the building- block approach to the material that we use.

Concept Check At the end of major chapter sections we include a brief list of questions that are designed to highlight key ideas presented in the section.

CHAPTER 2 • The Financial Markets and Interest Rates 41

someone for 1 year at a nominal rate of interest of 11.3 percent. This means you will get back $111.30 in 1 year. But if during the year, the prices of goods and services rise by 5 percent, it will take $105 at year-end to purchase the same goods and services that $100 purchased at the beginning of the year. What was your increase in purchas- ing power over the year? The quick and dirty answer is found by subtracting the inflation rate from the nominal rate, 11.3% 2 5% 5 6.3%, but this is not exactly cor- rect. We can also express the relationship among the nominal interest rate, the rate of inflation (that is, the inflation premium), and the real rate of interest as follows:

1 1 nominal interest rate 5 (1 1 real rate of interest)(1 1 rate of inflation) (2-3)

Solving for the nominal rate of interest,

Nominal interest rate 5 real rate of interest 1 rate of inflation 1 (real rate of interest) (rate of inflation)

Consequently, the nominal rate of interest is equal to the sum of the real rate of interest, the inflation rate, and the product of the real rate and the inflation rate. This relationship among nominal rates, real rates, and the rate of inflation has come to be called the Fisher effect. What does the product of the real rate of interest and the infla- tion rate represent? It represents the fact that the money you earn on your investment is worth less because of inflation. All this demonstrates that the observed nominal rate of interest includes both the real rate and an inflation premium.

Substituting into equation (2-3) using a nominal rate of 11.3 percent and an infla- tion rate of 5 percent, we can calculate the real rate of interest as follows:

Nominal or quoted rate of interest

5 real rate of interest 1 inflation rate

1 product of the real rate of interest and the inflation rate

0.113 5 real rate of interest 1 0.05 1 0.05 3 real rate of interest

0.063 5 1.05 3 real rate of interest

0.063/1.05 5 real rate of interest

Solving for the real rate of interest:

Real rate of interest = 0.06 = 6%

Thus, at the new higher prices, your purchasing power will have increased by only 6 percent, although you have $11.30 more than you had at the start of the year. To see why, let’s assume that at the outset of the year, one unit of the market basket of goods and services cost $1, so you could purchase 100 units with your $100. At the end of the year, you have $11.30 more, but each unit now costs $1.05 (remember the 5 percent rate of inflation). How many units can you buy at the end of the year? The answer is $111.30 4 $1.05 5 106, which represents a 6 percent increase in real purchasing power.2

Inflation and Real Rates of Return: The Financial Analyst’s Approach Although the algebraic methodology presented in the previous section is strictly cor- rect, few practicing analysts or executives use it. Rather, they employ some version of

2In Chapter 5, we will study more about the time value of money.

CAN YOU DO IT? Solving for the Real Rate of Interest Your banker just called and offered you the chance to invest your savings for 1 year at a quoted rate of 10 percent. You also saw on the news that the inflation rate is 6 percent. What is the real rate of interest you would be earning if you made the investment? (The solution can be found on page 42.)

M02_KEOW3285_09_SE_C02.indd 41 28/11/15 2:54 PM

42 PART 1 • The Scope and Environment of Financial Management

the following relationship (which comes from equation (2-2)), an approximation method, to estimate the real rate of interest over a selected past time frame.

Nominal interest rate 2 inflation rate > real interest rate

The concept is straightforward, but its implementation requires that several judg- ments be made. For example, suppose we want to use this relationship to determine the real risk-free interest rate. Which interest rate series and maturity period should be used? Suppose we settle for using some U.S. Treasury security as a surrogate for a nominal risk-free interest rate. Then, should we use the yield on 3-month U.S. Treasury bills or, perhaps, the yield on 30-year Treasury bonds? There is no absolute answer to the question.

So, we can have a real risk-free short-term interest rate, as well as a real risk-free long-term interest rate, and several variations in between. In essence, it just depends on what the analyst wants to accomplish. Of course we could also calculate the real rate of interest on some rating class of 30-year corporate bonds (such as Aaa-rated bonds) and have a risky real rate of interest as opposed to a real risk-free interest rate.

Furthermore, the choice of a proper inflation index is equally challenging. Again, we have several choices. We could use the consumer price index, the producer price index for finished goods, or some price index out of the national income accounts, such as the gross domestic product chain price index. Again, there is no precise scien- tific answer as to which specific price index to use. Logic and consistency do narrow the boundaries of the ultimate choice.

Let’s tackle a very basic (simple) example. Suppose that an analyst wants to esti-

DID YOU GET IT? Solving for the Real Rate of Interest

Nominal or quoted rate of interest

5 real rate of interest

1 inflation rate

1 product of the real rate of interest and the inflation rate

0.10 5 real rate of interest 1 0.06 1 0.06 3 real rate of interest

0.04 5 1.06 3 real rate of interest

Solving for the real rate of interest:

Real rate of interest 5 0.0377 5 3.77%

12 PART 1 • The Scope and Environment of Financial Management

right thing.” In a sense, we can think of laws as a set of rules that reflect the values of a society as a whole.

You might ask yourself, “As long as I’m not breaking society’s laws, why should I care about ethics?” The answer to this question lies in consequences. Everyone makes errors of judgment in business, which is to be expected in an uncertain world. But ethi- cal errors are different. Even if they don’t result in anyone going to jail, they tend to end careers and thereby terminate future opportunities. Why? Because unethical behavior destroys trust, and businesses cannot function without a certain degree of trust.

Concept Check 1. According to Principle 3, how do investors decide where to invest their money? 2. What is an efficient market? 3. What is the agency problem, and why does it occur? 4. Why are ethics and trust important in business?

The Role of Finance in Business Finance is the study of how people and businesses evaluate investments and raise capital to fund them. Our interpretation of an investment is quite broad. When Apple designed its Apple Watch, it was clearly making a long-term investment. The firm had to devote considerable expenses to designing, producing, and marketing the

LO3 Describe the role of finance in business.

Preface xxi

Financial Decision Tools A feature that has proven popular with students has been our recapping of key equations shortly after their discussion. Students get to see an equa- tion within the context of related equations.

Financial Calculators and Excel Spreadsheets The use of financial calculators and Excel spreadsheets has been integrated throughout the text, especially with respect to presenta- tion of the time value of money and valua- tion. Where appropriate, actual calculator and spreadsheet solutions appear in the text.

Chapter Summaries That Bring Together Concepts, Terminology, and Applications The chapter summaries have been written in a way that connects them to the in- chapter sections and learning objectives. For each learning objective, the student sees in one place the concepts, new terminology, and key equations that were presented in the objective.

Revised Study Problems With each edition, we have provided new and revised end-of-chapter study prob- lems to refresh their usefulness in teaching finance. Also, the study problems con- tinue to be organized according to learning objective so that both the instructor and student can readily align text and problem materials.

Comprehensive Mini Cases A comprehensive Mini Case appears at the end of almost every chapter, covering all the major topics included in that chapter. Each Mini Case can be used as a lecture or review tool by the professor. For the students, the Mini Case provides an opportunity to apply all the concepts presented within the chapter in a realistic setting, thereby strengthening their understanding of the material.

FINANCIAL DECISION TOOLS Name of Tool Formula What It Tells You

Return on equity net income

total common equity Measures the shareholders’ accounting return on their investment.

Concept Check 1. How is a company’s return on equity related to the firm’s operating return on assets? 2. How is a company’s return on equity related to the firm’s debt ratio? 3. What is the upside of debt financing? What is the downside?

02/12/15 2:00 PM

(5-2)

20

CALCULATOR SOLUTION

Data Input Function Key

10 N

6 I/Y

-500 FV

0 PMT

Function Key Answer

CPT

PV 279.20

MyFinanceLab Video

MyFinanceLab Video

02/12/15 2:11 PM

CHAPTER 2 • The Financial Markets and Interest Rates 53

Mini Case This Mini Case is available in MyFinanceLab.

On the first day of your summer internship, you’ve been assigned to work with the chief financial officer (CFO) of SanBlas Jewels Inc. Not knowing how well trained you are, the CFO has decided to test your understanding of interest rates. Specifi- cally, she asks you to provide a reasonable estimate of the nominal interest rate for a new issue of Aaa-rated bonds to be offered by SanBlas Jewels Inc. The final format that the chief financial officer of SanBlas Jewels has requested is that of equation (2-1) in the text. Your assignment also requires that you consult the data in Table 2-2.

Some agreed-upon procedures related to generating estimates for key variables in equation (2-1) follow.

a. The current 3-month Treasury bill rate is 2.96 percent, the 30-year Treasury bond rate is 5.43 percent, the 30-year Aaa-rated corporate bond rate is 6.71 percent, and the inflation rate is 2.33 percent.

b. The real risk-free rate of interest is the difference between the calculated aver- age yield on 3-month Treasury bills and the inflation rate.

c. The default-risk premium is estimated by the difference between the average yields on Aaa-rated bonds and 30-year Treasury bonds.

d. The maturity-risk premium is estimated by the difference between the average yields on 30-year Treasury bonds and 3-month Treasury bills.

e. SanBlas Jewels’ bonds will be traded on the New York Bond Exchange, so the liquidity-risk premium will be slight. It will be greater than zero, however, because the secondary market for the firm’s bonds is more uncertain than that of some other jewel sellers. It is estimated at 4 basis points. A basis point is one one-hundredth of 1 percent.

Now place your output into the format of equation (2-1) so that the nominal interest rate can be estimated and the size of each variable can also be inspected for reason- ableness and discussion with the CFO.

xxii Preface

A Complete Support Package for the Student and Instructor MyFinanceLab This fully integrated online homework system gives students the hands-on prac- tice and tutorial help they need to learn finance efficiently. Ample opportunities for online practice and assessment in MyFinanceLab are seamlessly integrated into each chapter. For more details, see the inside front cover.

Instructor’s Resource Center This password-protected site, accessible at http://www.pearsonhighered.com/irc, hosts all of the instructor resources that follow. Instructors should click on the “IRC Help Center” link for easy-to-follow instructions on getting access or may contact their sales representative for further information.

Test Bank This online Test Bank, prepared by Rodrigo Hernandez of Radford University, pro- vides more than 1,600 multiple-choice, true/false, and short-answer questions with complete and detailed answers. The online Test Bank is designed for use with the TestGen-EQ test-generating software. This computerized package allows instruc- tors to custom design, save, and generate classroom tests. The test program permits instructors to edit, add, or delete questions from the Test Bank; analyze test results; and organize a database of tests and student results. This software allows for greater flexibility and ease of use. It provides many options for organizing and displaying tests, along with a search and sort feature.

Instructor’s Manual with Solutions Written by the authors and updated by Mary Schranz, the Instructor’s Manual fol- lows the textbook’s organization and represents a continued effort to serve the teach- er’s goal of being effective in the classroom. Each chapter contains a chapter orienta- tion, answers to end-of-chapter review questions, and solutions to end-of-chapter study problems.

The Instructor’s Manual is available electronically, and instructors can download it from the Instructor’s Resource Center by visiting http://www.pearsonhighered. com/irc.

The PowerPoint Lecture Presentation This lecture presentation tool, prepared by Sonya Britt of Kansas State University, provides the instructor with individual lecture outlines to accompany the text. The slides include many of the figures and tables from the text. These lecture notes can be used as is, or instructors can easily modify them to reflect specific presentation needs.

Excel Spreadsheets Created by the authors, these spreadsheets correspond to end-of-chapter problems from the text. This student resource is available on MyFinanceLab.