Clients3 google comhttp generate 204

Finance Summary And Discussion

Write a summary after read the book chapter 1-4. (1-2 page)

1. what you have learned as a result of your reading, research

2. What you have learned from TD

3. Your comments (both positive and negative) about the Chat. What can be done in order to make it more valuable to you?

4. Your overall comments about your learning and experience for the week. What can I do to make this course more valuable to you?

Discussion questions: (also, you can answer it according to the book, and some other references are even better)

What is the rational for wealth maximization as a goal for a firm?
What are the key financial statements and why they are important?
What is the purpose of ratio analysis?
What is the concept of time value of money?
Why understanding of time value of money is important?

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FREQUENTLY USED SYMBOLS Term for book Definition

ACP Average collection period ADR American Depository Receipt AFN Additional funds needed APR Annual percentage rate

AR Accounts receivable b Beta coefficient in the CAPM

bL Levered beta bU Unlevered beta

BEP Basic earning power BVPS Book value per share

CAPM Capital Asset Pricing Model CCC Cash conversion cycle

CF Cash flow; CFt is the cash flow in Period t CFPS Cash flow per share

COGS Cost of goods sold COViM Covariance between stock i and the market

CR (1) Capital requirement ratio (2) Conversion ratio

CV Coefficient of variation D/E Debt-to-equity ratio

Δ Difference, or change (uppercase delta) di Input to the Black-Scholes option pricing model

Dps Dividend of preferred stock Dt Dividend of common stock in Period t

DCF Discounted cash flow DPS Dividends per share

DRIP Dividend reinvestment plan DRP Default risk premium DSO Days sales outstanding EAR Effective annual rate, EFF%

EBIT Earnings before interest and taxes; net operating income EBITDA Earnings before interest, taxes, depreciation, and amortization

EFF% Effective annual rate, EAR EPS Earnings per share

EVA Economic Value Added F (1) Flotation cost percentage

(2) Fixed operating costs FCF Free cash flow

FVAN Future value of an annuity for N years FVN Future value for Year N

g Growth rate in earnings, dividends, and stock prices gL Constant long-term growth rate in earnings, dividends, and stock prices

HVT Horizon value of stock or company at time T I Interest rate; also denoted by r

I/YR Interest rate key on some calculators INT Interest payment in dollars

IP Inflation premium IPO Initial public offering IRR Internal rate of return

LP Liquidity premium M/B Market-to-book ratio

M (1) Number of periods per year (2) Maturity value of a bond (3) Margin (profit margin)

MIRR Modified Internal Rate of Return MRP Maturity risk premium MVA Market Value Added

n Number of shares outstanding N Calculator key denoting number of periods

N di Area under a standard normal distribution to the left of di NOPAT Net operating profit after taxes NOWC Net operating working capital

NPV Net present value OP Operating profitability ratio

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P/E Price/earnings ratio P (1) Stock price; price in Period t Pt; current price P0

(2) Sales price per unit of product sold Pc Conversion price P^ 0 Expected stock price as PV of expected dividends Pf Price of good in foreign country Ph Price of good in home country PI Profitability index

PN A stock’s horizon value PM Profit margin

PMT Payment of an annuity PPP Purchasing power parity PV Present value

PVAN Present value of an annuity for N years Q Quantity produced or sold

QBE Breakeven quantity r (1) Percentage interest rate

(2) Required rate of return r− “r bar,” actual rate of return

r* Real risk-free rate of return r̂ “r hat,” expected rate of return

rd Required return on debt re Cost of new common stock including flotation costs rf Interest rate in foreign country rh Interest rate in home country ri Required return for an individual firm or security

rM Required return for “the market” or for an “average” stock rNOM Nominal rate of interest; also denoted by INOM

rp Required return on portfolio rps Required return on preferred stock

rPER Periodic rate of return rRF Rate of return on a risk-free security

rs Required return on common stock r−SMB Return on Fama-French small (size) minus big (size) portfolio r−HML Return on Fama-French high (B/M) minus big (B/M) portfolio

ρ Correlation coefficient (lowercase rho) R Estimated correlation coefficient for sample data

ROA Return on assets ROE Return on equity

ROIC Return on invested capital RPi Risk premium for Stock i

RPM Market risk premium RR Retention rate

S (1) Sales (2) Estimated standard deviation for sample data (3) Intrinsic value of stock (i.e., all common equity)

Σ Summation sign (uppercase sigma) σ Standard deviation (lowercase sigma)

σ2 Variance SML Security Market Line

t Time period T Marginal income tax rate

TIE Times interest earned TVN A stock’s horizon, or terminal, value

V Variable cost per unit VB Bond value VC Total variable costs VL Total market value of a levered firm

Vop Value of operations Vps Value of preferred stock VU Total market value of an unlevered firm

w Proportion or weight wd Weight of debt

wps Weight of preferred stock ws Weight of common stock

WACC Weighted average cost of capital X Exercise price of option

YTC Yield to call YTM Yield to maturity

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Corporate Finance A Focused Approach

6e

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

E U G E N E F . B R I G H A M University of Florida

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Corporate Finance: A Focused Approach, Sixth Edition Michael C. Ehrhardt and Eugene F. Brigham

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Brief Contents

Preface ix

PART 1 THE COMPANY AND ITS ENVIRONMENT 1 CHAPTER 1 An Overview of Financial Management

and the Financial Environment 3 Web Extensions 1A: An Overview of Derivatives

CHAPTER 2 Financial Statements, Cash Flow, and Taxes 57 Web Extension 2A: The Federal Income Tax System for

Individuals CHAPTER 3 Analysis of Financial Statements 101

PART 2 FIXED INCOME SECURITIES 137

CHAPTER 4 Time Value of Money 139 Web Extensions 4A: The Tabular Approach

4B: Derivation of Annuity Formulas 4C: Continuous Compounding

CHAPTER 5 Bonds, Bond Valuation, and Interest Rates 193

Web Extensions 5A: A Closer Look at Zero Coupon and Other OID Bonds

Web Extensions 5B: A Closer Look at TIPS: Treasury Inflation-Protected Securities

Web Extensions 5C: A Closer Look at Bond Risk: Duration Web Extensions 5D: The Pure Expectations Theory and

Estimation of Forward Rates

PART 3 STOCKS AND OPTIONS 239

CHAPTER 6 Risk and Return 241 Web Extensions 6A: Continuous Probability Distributions Web Extensions 6B: Estimating Beta with a Financial Calculator

CHAPTER 7 Corporate Valuation and Stock Valuation 293 Web Extension 7A: Derivation of Valuation Equations

CHAPTER 8 Financial Options and Applications in Corporate Finance 343

PART 4 PROJECTS AND THEIR VALUATION 373 CHAPTER 9 The Cost of Capital 375

Web Extension 9A: The Required Return Assuming Nonconstant Dividends and Stock Repurchases

CHAPTER 10 The Basics of Capital Budgeting: Evaluating Cash Flows 413

Web Extension 10A: The Accounting Rate of Return (ARR) CHAPTER 11 Cash Flow Estimation and Risk Analysis 453 Web Extension 11A: Certainty Equivalents and Risk-

Adjusted Discount Rates

PART 5 CORPORATE VALUATION AND GOVERNANCE 501

CHAPTER 12 Corporate Valuation and Financial Planning 503

CHAPTER 13 Corporate Governance 541

PART 6 CASH DISTRIBUTIONS AND CAPITAL STRUCTURE 563 CHAPTER 14 Distributions to Shareholders: Dividends

and Repurchases 565 CHAPTER 15 Capital Structure Decisions 607 Web Extension 15A: Degree of Leverage Web Extension 15B: Capital Structure Theory: Arbitrage

Proofs of the Modigliani-Miller Theorems

PART 7 MANAGING GLOBAL OPERATIONS 653 CHAPTER 16 Supply Chains and Working Capital

Management 655 Web Extension 16A: Secured Short-Term Financing CHAPTER 17 Multinational Financial

Management 705

APPENDIXES

APPENDIX A Solutions to Self-Test Problems 749 APPENDIX B Answers to End-of-Chapter Problems 773 APPENDIX C Selected Equations 781 APPENDIX D Values of the Areas under the

Standard Normal Distribution Function 791

GLOSSARY AND INDEXS

Glossary 793 Name Index 831 Subject Index 833

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Contents

Preface ix

PART 1 THE COMPANY AND ITS ENVIRONMENT 1

CHAPTER 1

An Overview of Financial Management and the Financial Environment 3 The Five-Minute MBA 4 Finance from 40,000 Feet Above 4 The Corporate Life Cycle 5 Governing a Corporation 10

Box: Be Nice with a B-Corp 12 Box: Taxes and Whistleblowing 14

An Overview of Financial Markets 14 Claims on Future Cash Flows: Types of Financial Securities 16 Claims on Future Cash Flows: The Required Rate of Return

(The Cost of Money) 20 The Functions of Financial Institutions 24 Financial Markets 29 Overview of the U.S. Stock Markets 33 Trading in the Modern Stock Markets 34

Box: Measuring the Market 42

Finance and the Great Recession of 2007 42 Box: Anatomy of a Toxic Asset 50

The Big Picture 52 e-Resources 53 Summary 53 Web Extensions

1A: An Overview of Derivatives

CHAPTER 2

Financial Statements, Cash Flow, and Taxes 57

Box: Intrinsic Value, Free Cash Flow, and Financial Statements 58

Financial Statements and Reports 58 The Balance Sheet 59

Box: The Great Recession of 2007: Let s Play Hide-and-Seek! 62

The Income Statement 62 Statement of Stockholders’ Equity 65

Box: Financial Analysis on the Web 66

Statement of Cash Flows 66 Box: Filling in the GAAP 69

Net Cash Flow 70 Free Cash Flow: The Cash Flow Available for Distribution to

Investors 70 Box: Sarbanes-Oxley and Financial Fraud 76

Performance Evaluation 78 The Federal Income Tax System 84

Box: When It Comes to Taxes, History Repeats and Repeals Itself! 86

Summary 89 Web Extension

2A: The Federal Income Tax System for Individuals

CHAPTER 3

Analysis of Financial Statements 101

Box: Intrinsic Value and Analysis of Financial Statements 102

Financial Analysis 102 Liquidity Ratios 104 Asset Management Ratios 106 Debt Management Ratios 109

Box: The Great Recession of 2007: The Price Is Right! (Or Wrong!) 110

Profitability Ratios 114 Box: The World Might Be Flat, but Global Accounting Is Bumpy! The Case of IFRS versus FASB 115

Market Value Ratios 116 Trend Analysis, Common Size Analysis, and Percentage

Change Analysis 120 Tying the Ratios Together: The DuPont Equation 123 Comparative Ratios and Benchmarking 124 Uses and Limitations of Ratio Analysis 125

Box: Ratio Analysis on the Web 126

Looking Beyond the Numbers 126 Summary 127

PART 2 FIXED INCOME SECURITIES 137 CHAPTER 4

Time Value of Money 139 Box: Corporate Valuation and the Time Value of Money 140

Time Lines 140

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Future Values 141 Box: Hints on Using Financial Calculators 145

Present Values 149 Box: It s a Matter of Trust 150

Finding the Interest Rate, I 153 Finding the Number of Years, N 154 Perpetuities 154 Annuities 155 Future Value of an Ordinary Annuity 156

Box: The Power of Compound Interest 159

Future Value of an Annuity Due 159 Present Value of Ordinary Annuities and Annuities Due 160 Finding Annuity Payments, Periods, and Interest Rates 162

Box: Variable Annuities: Good or Bad? 163 Box: Using the Internet for Personal Financial Planning 164

Uneven, or Irregular, Cash Flows 165 Future Value of an Uneven Cash Flow Stream 168 Solving for I with Irregular Cash Flows 169 Semiannual and Other Compounding Periods 170

Box: Truth in Lending: What Loans Really Cost 173 Fractional Time Periods 174 Amortized Loans 175

Box: What You Know Is What You Get: Not in Payday Lending 176

Growing Annuities 178 Box: The Great Recession of 2007: An Accident Waiting to Happen: Option Reset Adjustable Rate Mortgages 179

Summary 181 Web Extensions

4A: The Tabular Approach 4B: Derivation of Annuity Formulas 4C: Continuous Compounding

CHAPTER 5

Bonds, Bond Valuation, and Interest Rates 193 Box: Intrinsic Value and the Cost of Debt 194

Who Issues Bonds? 194 Box: Betting With or Against the U.S. Government: The Case of Treasury Bond Credit Default Swaps 196

Key Characteristics of Bonds 196

Bond Valuation 200

Changes in Bond Values Over Time 205 Box: Chocolate Bonds 208

Bonds with Semiannual Coupons 208 Bond Yields 209 The Pre-Tax Cost of Debt: Determinants of Market Interest

Rates 212 The Risk-Free Interest Rate: Nominal (rRF) and Real (r*) 213 The Inflation Premium (IP) 214 The Maturity Risk Premium (MRP) 216

The Default Risk Premium (DRP) 219 Box: Insuring with Credit Default Swaps: Let the Buyer Beware! 221 Box: The Great Recession of 2007: U.S. Treasury Bonds Downgraded! 223 Box: The Few, the Proud, the AAA-Rated Companies! 225

The Liquidity Premium (LP) 225 Box: The Great Recession of 2007: Fear and Rationality 226

The Term Structure of Interest Rates 226 Financing with Junk Bonds 228 Bankruptcy and Reorganization 228 Summary 229 Web Extensions

5A: A Closer Look at Zero Coupon and Other OID Bonds

5B: A Closer Look at TIPS: Treasury Inflation-Protected Securities

5C: A Closer Look at Bond Risk: Duration

5D: The Pure Expectations Theory and Estimation of Forward Rates

PART 3 STOCKS AND OPTIONS 239 CHAPTER 6

Risk and Return 241 Box: Intrinsic Value, Risk, and Return 242

Investment Returns and Risk 242 Measuring Risk for Discrete Distributions 243 Risk in a Continuous Distribution 247

Box: What Does Risk Really Mean? 249

Using Historical Data to Estimate Risk 249 Box: The Historic Trade-Off between Risk and Return 252

Risk in a Portfolio Context 252 The Relevant Risk of a Stock: The Capital Asset Pricing Model

(CAPM) 256 Box: The Benefits of Diversifying Overseas 263

The Relationship between Risk and Return in the Capital Asset Pricing Model 263 Box: Another Kind of Risk: The Bernie Madoff Story 271

The Efficient Markets Hypothesis 272 The Fama-French Three-Factor Model 276 Behavioral Finance 280 The CAPM and Market Efficiency: Implications for Corporate

Managers and Investors 282 Summary 283 Web Extensions

6A: Continuous Probability Distributions 6B: Estimating Beta with a Financial Calculator

CHAPTER 7

Corporate Valuation and Stock Valuation 293 Box: Corporate Valuation and Stock Prices 294

Contents v

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Legal Rights and Privileges of Common Stockholders 294 Types of Common Stock 295 Stock Market Reporting 296 Valuing Common Stocks—Introducing the Free Cash Flow

(FCF) Valuation Model 297 The Constant Growth Model: Valuation When Expected Free

Cash Flow Grows at a Constant Rate 300 The Multistage Model: Valuation when Expected Short-Term

Free Cash Flow Grows at a Nonconstant Rate 305 Application of the FCF Valuation Model to MicroDrive 309 Do Stock Values Reflect Long-Term or Short-Term Cash

Flows? 315 Value-Based Management: Using the Free Cash Flow Valuation

Model to Identify Value Drivers 316 Why Are Stock Prices So Volatile? 319 Valuing Common Stocks with the Dividend Growth Model 320 The Market Multiple Method 328 Comparing the FCF Valuation Model, the Dividend Growth

Model, and the Market Multiple Method 329 Preferred Stock 330 Summary 331 Web Extensions

7A: Derivation of Valuation Equations

CHAPTER 8

Financial Options and Applications in Corporate Finance 343

Box: The Intrinsic Value of Stock Options 344

Overview of Financial Options 344 The Single-Period Binomial Option Pricing Approach 347

Box: Financial Reporting for Employee Stock Options 348

The Single-Period Binomial Option Pricing Formula 353 The Multi-Period Binomial Option Pricing Model 355 The Black-Scholes Option Pricing Model (OPM) 357

Box: Taxes and Stock Options 362

The Valuation of Put Options 363 Applications of Option Pricing in Corporate Finance 365 Summary 367

PART 4 PROJECTS AND THEIR VALUATION 373

CHAPTER 9

The Cost of Capital 375 Box: Corporate Valuation and the Cost of Capital 376

The Weighted Average Cost of Capital 376 Choosing Weights for the Weighted Average Cost of Capital 378 After-Tax Cost of Debt: rd 1 T and rstd 1 T 379

Box: How Effective Is the Effective Corporate Tax Rate? 382

Cost of Preferred Stock, rps 384

Cost of Common Stock: The Market Risk Premium, RPM 384 Using the CAPM to Estimate the Cost of Common Stock, rs 388 Using the Dividend Growth Approach to Estimate the Cost of

Common Stock 390 The Weighted Average Cost of Capital (WACC) 393

Box: Global Variations in the Cost of Capital 395

Adjusting the Cost of Equity for Flotation Costs 395 Privately Owned Firms and Small Businesses 397 The Divisional Cost of Capital 398 Estimating the Cost of Capital for Individual Projects 401 Managerial Issues and the Cost of Capital 402 Summary 404 Web Extensions

9A: The Required Return Assuming Nonconstant Dividends and Stock Repurchases

CHAPTER 10

The Basics of Capital Budgeting: Evaluating Cash Flows 413

Box: Corporate Valuation and Capital Budgeting 414

An Overview of Capital Budgeting 414 The First Step in Project Analysis 416 Net Present Value (NPV) 417 Internal Rate of Return (IRR) 419 Modified Internal Rate of Return (MIRR) 426 Profitability Index (PI) 429 Payback Period 430 How to Use the Different Capital Budgeting Methods 432 Other Issues in Capital Budgeting 435 Summary 441 Web Extensions

10A: The Accounting Rate of Return (ARR)

CHAPTER 11

Cash Flow Estimation and Risk Analysis 453

Box: Project Valuation, Cash Flows, and Risk Analysis 454

Identifying Relevant Cash Flows 454 Analysis of an Expansion Project 459

Box: Mistakes in Cash Flow Estimation Can Kill Innovation 466

Risk Analysis in Capital Budgeting 467 Measuring Stand-Alone Risk 467 Sensitivity Analysis 468 Scenario Analysis 471 Monte Carlo Simulation 474 Project Risk Conclusions 477 Replacement Analysis 478 Real Options 480 Phased Decisions and Decision Trees 482

vi Contents

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Summary 485 Web Extensions

11A: Certainty Equivalents and Risk-Adjusted Discount Rates

PART 5 CORPORATE VALUATION AND GOVERNANCE 501 CHAPTER 12

Corporate Valuation and Financial Planning 503 Box: Corporate Valuation and Financial Planning 504

Overview of Financial Planning 504 Financial Planning at MicroDrive, Inc. 506 Forecasting Operations 508 Evaluating MicroDrive’s Strategic Initiatives 512 Projecting MicroDrive’s Financial Statements 515 Analysis and Selection of a Strategic Plan 519 The CFO’s Model 521 Additional Funds Needed (AFN) Equation Method 523 Forecasting When the Ratios Change 526 Summary 530

CHAPTER 13

Corporate Governance 541 Box: Corporate Governance and Corporate Valuation 542

Agency Conflicts 542 Corporate Governance 545

Box: Would the U.S. Government Be an Effective Board Director? 550 Box: The Dodd-Frank Act and Say on Pay 552 Box: The Sarbanes-Oxley Act of 2002 and Corporate Governance 553 Box: International Corporate Governance 555

Employee Stock Ownership Plans (ESOPs) 557 Summary 560

PART 6 CASH DISTRIBUTIONS AND CAPITAL STRUCTURE 563

CHAPTER 14

Distributions to Shareholders: Dividends and Repurchases 565

Box: Uses of Free Cash Flow: Distributions to Shareholders 566

An Overview of Cash Distributions 566 Procedures for Cash Distributions 568 Cash Distributions and Firm Value 571 Clientele Effect 575 Signaling Hypothesis 576 Implications for Dividend Stability 577

Box: The Great Recession of 2007: Will Dividends Ever Be the Same? 578

Setting the Target Distribution Level: The Residual Distribution Model 578

The Residual Distribution Model in Practice 580 A Tale of Two Cash Distributions: Dividends versus Stock

Repurchases 581 The Pros and Cons of Dividends and Repurchases 590

Box: Dividend Yields around the World 592

Other Factors Influencing Distributions 592 Summarizing the Distribution Policy Decision 594 Stock Splits and Stock Dividends 595

Box: The Great Recession of 2007: Talk About a Split Personality! 596

Dividend Reinvestment Plans 598 Summary 599

CHAPTER 15

Capital Structure Decisions 607 Box: Corporate Valuation and Capital Structure 608

An Overview of Capital Structure 608 Business Risk and Financial Risk 610 Capital Structure Theory: The Modigliani and Miller

Models 614 Box: Yogi Berra on the MM Proposition 616

Capital Structure Theory: Beyond the Modigliani and Miller Models 618

Capital Structure Evidence and Implications 623 Estimating the Optimal Capital Structure 628 Anatomy of a Recapitalization 634

Box: The Great Recession of 2007: Deleveraging 639

Risky Debt and Equity as an Option 639 Managing the Maturity Structure of Debt 642 Summary 645 Web Extensions

15A: Degree of Leverage

15B: Capital Structure Theory: Arbitrage Proofs of the Modigliani-Miller Theorems

PART 7 MANAGING GLOBAL OPERATIONS 653 CHAPTER 16

Supply Chains and Working Capital Management 655

Box: Corporate Valuation and Working Capital Management 656

Overview of Supply Chain Management 656 Using and Financing Operating Current Assets 658 The Cash Conversion Cycle 662

Contents vii

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Box: Some Firms Operate with Negative Working Capital! 667

Inventory Management 668 Receivables Management 669

Box: Supply Chain Finance 671

Accruals and Accounts Payable (Trade Credit) 673 Box: A Wag of the Finger or Tip of the Hat? The Colbert Report and Small Business Payment Terms 674

The Cash Budget 677 Cash Management and the Target Cash Balance 681

Box: Use It or Lose Part of It: Cash Can Be Costly! 682

Cash Management Techniques 682 Managing Short-Term Investments 685

Box: Your Check Isn t in the Mail 686

Short-Term Financing 687 Short-Term Bank Loans 688 Commercial Paper 692 Use of Security in Short-Term Financing 692 Summary 693 Web Extensions

16A: Secured Short-Term Financing

CHAPTER 17

Multinational Financial Management 705 Box: Corporate Valuation in a Global Context 706

Multinational, or Global, Corporations 706 Multinational versus Domestic Financial Management 707 Exchange Rates 709 Exchange Rates and International Trade 714 The International Monetary System and Exchange Rate

Policies 715

Trading in Foreign Exchange 720 Interest Rate Parity 722 Purchasing Power Parity 724

Box: Hungry for a Big Mac? Go to Ukraine! 725

Inflation, Interest Rates, and Exchange Rates 726 International Money and Capital Markets 726

Box: Greasing the Wheels of International Business 727 Box: Stock Market Indices around the World 731

Multinational Capital Budgeting 732 Box: Consumer Finance in China 733 Box: Double Irish with a Dutch Twist 735

International Capital Structures 737 Multinational Working Capital Management 738 Summary 741

APPENDIXES

Appendix a Solutions to Self-Test Problems 749

Appendix b Answers to End-of-Chapter Problems 773

Appendix c Selected Equations 781

Appendix d Values of the Areas under the Standard Normal Distribution Function 791

GLOSSARY AND INDEXES

Glossary 793 Name Index 831 Subject Index 833

viii Contents

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Preface

When we wrote the first edition of Corporate Finance: A Focused Approach, we had four goals: (1) to create a text that would help students make better financial decisions; (2) to provide a book that covers the core material necessary for a one-semester introductory MBA course but without all the other interesting-but-not-essential material that is contained in most MBA texts; (3) to motivate students by demonstrating that finance is both interesting and relevant; and (4) to make the book clear enough so that students could go through the material without wasting either their time or their professors’ time trying to figure out what we were saying.

The events precipitating the recession of 2007, the dramatic changes in financial technology at stock exchanges across the world, and the sovereign debt crisis in Greece make it more important than ever for students and managers to understand the role that finance plays in a global economy, in their own companies, and in their own lives. So in addition to the four goals listed above, this edition has a fifth goal: to prepare students for a changed world.

Intrinsic Valuation as a Unifying Theme Our emphasis throughout the book is on the actions that a manager can and should take to increase the intrinsic value of the firm. Structuring the book around intrinsic valuation enhances continuity and helps students see how various topics are related to one another.

As the title indicates, this book combines theory and practical applications. An understanding of finance theory is essential for anyone developing and/or implementing effective financial strategies. But theory alone isn’t sufficient, so we provide numerous examples in the book and the accom- panying Excel spreadsheets to illustrate how theory is applied in practice. Indeed, we believe that the ability to analyze financial problems using Excel also is essential for a student’s successful job search and subsequent career. Therefore, many exhibits in the book come directly from the accompanying Excel spreadsheets. Many of the spreadsheets also provide brief “tutorials” by way of detailed comments on Excel features that we have found to be especially useful, such as Goal Seek, Tables, and many financial functions.

The book begins with fundamental concepts, including background on the economic and financial environment, financial statements (with an emphasis on cash flows), the time value of money, bond valuation, risk analysis, and stock valuation. With this background, we go on to discuss how specific techniques and decision rules can be used to help maximize the value of the firm. This organization provides four important advantages:

1. Managers should try to maximize the intrinsic value of a firm, which is determined by cash flows as revealed in financial statements. Our early coverage of financial statements helps students see how particular financial decisions affect the various parts of the firm and the resulting cash flow. Also, financial statement analysis provides an excellent vehicle for illustrating the usefulness of spreadsheets.

2. Covering time value of money early helps students see how and why expected future cash flows determine the value of the firm. Also, it takes time for students to digest TVM concepts and to learn how to do the required calculations, so it is good to cover TVM concepts early and often.

3. Most students—even those who do not plan to major in finance—are interested in investments. The ability to learn is a function of individual interest and motivation, so Corporate Finance’s early coverage of securities and security markets is pedagogically sound.

4. Once basic concepts have been established, it is easier for students to understand both how and why corporations make specific decisions in the areas of capital budgeting, raising capital, working capital management, mergers, and the like.

r e s o u r c e Students: Access the Corporate Finance: A Focused Approach (6th Edition) companion site and online student resources by visiting www.cengagebrain .com, searching ISBN 9781305637108, and clicking “Access Now” under “Study Tools” to go to the student textbook companion site.

Instructors: Access the Corporate Finance: A Focused Approach (6th Edition) companion site and instructor resources by going to login. cengage.com, logging in with your faculty account username and password, and using ISBN 9781305637108 to reach the site through your account.

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Copyright 2017 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.

Intended Market and Use Corporate Finance is designed primarily for use in the introductory MBA finance course and as a reference text in follow-on case courses and after graduation. The book can also be used as an undergraduate introductory text for exceptionally good students.

Improvements in the 6th Edition As in every revision, we updated and clarified materials throughout the text, reviewing the entire book for completeness, ease of exposition, and currency. We made hundreds of small changes to keep the text up to date, with particular emphasis on updating the real-world examples and including the latest changes in the financial environment and financial theory. In addition, we made a number of larger changes. Some affect all chapters, some involve reorganizing sections among chapters, and some modify material covered within specific chapters.

Changes That Affect All Chapters Following are some of the changes that affect all chapters.

THE GREAT RECESSION OF 2007 In every chapter we use real-world examples to show how the chapter’s topics are related to some aspect of the global economic crisis. In addition, many chapters have “Great Recession of 2007” boxes that focus on important issues related to the recent recession.

CONTINUED INTEGRATION WITH EXCEL We have continued to integrate the textbook and the accompanying Excel Tool Kit spreadsheet models for each chapter. Many figures in the textbook show the appropriate area from the chapter’s Excel Tool Kit model. This makes the analysis more transparent to the students and better enables them to follow the analysis in the Excel model.

Notable Changes within Selected Chapters We made too many small improvements within each chapter to mention them all, but some of the more notable ones are discussed below.

CHAPTER 1: AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT We added a new, short section, “1-2 Finance from 40,000 Feet Above,” to give students an overview of the main issues in finance. We added more coverage of ethics in Section 1-4c, including a new box on benefit corporations, “Be Nice with a B-Corp,” and a box on whistleblowing, “Taxes and Whistleblow- ing.” We completely rewrote the sections on trading procedures (Section 1-9c) and the stock market (Section 1-10) to reflect the impact of Reg NMS and automated trading, including a section (1-10d) on high-frequency trading.

CHAPTER 2: FINANCIAL STATEMENTS, CASH FLOW, AND TAXES In past editions, we introduced the operating profitability ratio and the capital requirement ratio in later chapters, but we now introduce them in our discussion of the return on invested capital (ROIC) in Section 2-8a because they provide insight into the sources of ROIC (i.e., profitability and capital utilization). We also use these ratios in our expanded coverage of the free cash flow valuation model in Chapter 7 (Corporate Valuation and Stock Valuation).

CHAPTER 5: BONDS, BOND VALUATION, AND INTEREST RATES We added a new box on “Chocolate Bonds.” We also streamlined and improved our discussions of the real risk-free rate and the nominal risk-free rate in Section 5-8.

CHAPTER 7: CORPORATE VALUATION AND STOCK VALUATION We expanded the material on the free cash flow corporate valuation model and moved it so that it now precedes the dividend growth model. We did this because most companies don’t pay a dividend and because most practitioners use the free cash flow corporate valuation model. The expanded coverage now illustrates the valuation of MicroDrive, which was formerly shown in Chapter 12 (Corporate Valuation and Financial Planning). This allows us to emphasize valuation (and value- based management) in Chapter 7 and to emphasize financial planning in Chapter 12. The expanded FCF valuation treatment in Chapter 7 now covers forecasting free cash flows and identifying value

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drivers in much more detail (we also included a corresponding Spreadsheet Problem in the end-of- chapter problems). We also use the FCF valuation model to frame the discussion of stock price volatility and the relative values of cash flows in the first four years versus the value of later cash flows (we illustrated these concepts using the dividend growth model in previous editions). We have been using this approach in our own classrooms for several years and have found it to be effective.

CHAPTER 11: CASH FLOW ESTIMATION AND RISK ANALYSIS We added a new box, “Mistakes in Cash Flow Estimation Can Kill Innovation,” describing common mistakes in project analysis that are made by many managers.

CHAPTER 12: CORPORATE VALUATION AND FINANCIAL PLANNING We expanded our coverage of valuation and included an additional Spreadsheet Problem on valuation. We did this to reinforce our treatment of valuation in Chapter 7.

CHAPTER 15: CAPITAL STRUCTURE DECISIONS We added a short section (15-8) discussing insights gained from comparing the equity in a risky levered firm with a call option written on the underlying value of the firm, with an expiration equal to the debt’s maturity and a strike price equal to the debt’s face value. We also included a short section (15-9) discussing the debt maturity choice and providing recent empirical evidence on the shift away from long-term debt. For those instructors wishing to cover the Modigliani and Miller proofs, we have added a new Web Extension (15B) and PowerPoint file showing the MM proofs.

CHAPTER 16: SUPPLY CHAINS AND WORKING CAPITAL MANAGEMENT We improved our discussion of the cash conversion cycle and reduced its length by simplifying the example. To more quickly reinforce the concepts of the cash conversion cycle, we now follow it immediately with coverage of inventory management, receivables management, and payables management. We added a new section (16-9a) that explains the U.S. payment, clearing, and settlement infrastructure. We added a box on the recent phenomenon of banks charging corporate customers for cash deposit accounts, “Use It or Lose Part of It: Cash Can Be Costly!”

CHAPTER 17: MULTINATIONAL FINANCIAL MANAGEMENT A new opening vignette uses Medtronic and Covidien to illustrate a tax inversion merger.

Learning Tools Available to Students and Instructors Corporate Finance includes a broad range of ancillary materials designed to enhance students’ learning and to make it easier for instructors to prepare for and conduct classes. All resources available to students are, of course, also available to instructors; in addition, instructors have access to the course management tools.

In addition to these resources and the items noted previously, many other resources are available on the Web at Corporate Finance’s Web site. These ancillaries include the following.

Excel Tool Kits Proficiency with spreadsheets is an absolute necessity for all MBA students. With that in mind, for each chapter we created Excel spreadsheets, called Tool Kits, to show how the calculations used in the chapter were done. The Tool Kit models include explanations that show students how to use many of the features and functions of Excel, enabling the Tool Kits to serve as self-taught tutorials.

Web Extensions Many chapters have Adobe PDF “appendices” that provide more detailed coverage of topics that were addressed in the chapter.

End-of-Chapter Spreadsheet Problems Each chapter has a Build a Model problem, where students start with a spreadsheet that contains financial data plus general instructions about solving a specific problem. The model is partially completed, with headings but no formulas, so the student must literally build a model. This structure guides the student through the problem, minimizes unnecessary typing and data entry, and also makes it easy to grade the work, because all students’ answers are in the same locations on the spreadsheet. The

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partial spreadsheets for the Build a Model problems are available to students on the book’s Web site; the completed models are in files on the Instructor’s portion of the Web site.

Interactive Study Center The textbook’s Web site contains links to all Web sites that are cited in each chapter.

Course Management Tools Available Only to Instructors Instructors have access to all of the materials listed above in addition to course management tools. These tools are available at Corporate Finance’s Instructor companion Web site. These materials include the following resources.

Solutions Manual This comprehensive manual contains worked-out solutions to all end-of-chapter materials. It is available in electronic form at the Instructor’s Web site.

PowerPoint Slides For each chapter, we provide a set of PowerPoint slides that present graphs, tables, lists, and calculations for use in lectures. Although the slides correspond to the Mini Cases at the end of the chapter, the slides are completely self-contained in the sense that they can be used for lectures regardless of whether students have read the Mini Cases. In fact, we often don’t assign the Mini Case, but we do use the PowerPoint slides. Copies of these files are on the Instructor’s Web site and the CengageNOWTM site.

Instructors can easily customize the slides and convert them quickly into any PowerPoint Design Template.1 If you add some of your own slides or modify the existing slides to better illustrate important concepts, please share your changes with us—many of our best learning points have come from instructors and we appreciate all suggestions for ways to improve learning experiences for students.

In addition to the slides, there is a Mini Case at the end of each chapter. We assign the Mini Cases only for specific chapters, but some professors assign the Mini Cases for most chapters. These cases cover all the essential issues presented in the chapter, and they provide the structure for our class lectures even if we don’t assign the Mini Case.

Mini Case Spreadsheets In addition to the PowerPoint slides, we also provide Excel spreadsheets that perform the calculations required in the Mini Cases. These spreadsheets are similar to the Tool Kits, but with two differences. (1) The numbers correspond to the Mini Cases rather than the chapter examples. (2) We added some features that enable “what if” analysis on a real-time basis in class.

We usually begin our lectures with the PowerPoint presentation, but after we have explained a basic concept, we “toggle” to the Mini Case Excel file and show how the analysis can be done in Excel.2

For example, when teaching bond pricing, we begin with the PowerPoint show and cover the basic concepts and calculations. Then we toggle to Excel and use a sensitivity-based graph to show how bond prices change as interest rates and time to maturity vary. More and more students are bringing their laptops to class—they can follow along and do the “what if” analysis for themselves.

Solutions to End-of-Chapter Spreadsheet Problems The partial spreadsheets for the Build a Model problems are available to students, and the completed models are in files on the Instructor’s Web site.

NEW! Test Banks in Cognero The Test Bank for Corporate Finance is now available online in a new system named Cengage Learning Testing Powered by Cognero. This is a flexible, online system that allows instructors to:

1To convert into a different design template in PowerPoint for Office 2010, select Design, Theme, and choose a theme. Always double-check the conversion; some templates use fonts of different sizes, which can cause some slide titles to run over their allotted space. 2To toggle between two open programs, such as Excel and PowerPoint, hold the Alt key down and hit the Tab key until you have selected the program you want to show.

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• Author, edit, and manage test bank content. • Use searchable metadata to ensure tests are complete and compliant. • Create multiple test versions in an instant. • Deliver tests from your Learning Management System (LMS), your classroom, or anywhere you

have online access.

Cengage Learning Testing Powered by Cognero works on any operating system or browser with no special installs or downloads needed. With its intuitive tools and familiar desktop drop-down menus, Cognero enables instructors to easily create and edit tests from school or home—anywhere with Internet access.

In addition to the Test Bank available online through Cognero, the Test Bank is also available in a number of file formats on the Instructor companion Web site. Each chapter’s bank of questions includes dozens of True/False, Multiple Choice, and Essay questions. Instructors can retrieve the appropriate file formats to administer tests through their schools’ learning management systems (Blackboard, Canvas, Moodle, Desire2Learn, etc.), or they can opt for Word documents.

The Test Bank contains more than 1,200 class-tested questions and problems. Information regarding the topic and degree of difficulty, along with the complete solution for all numerical problems, is provided with each question.

Additional Course Tools MindTap Finance for Corporate Finance: A Focused Approach Corporate Finance: A Focused Approach, 6th Edition, includes a brand new MindTap learning experience, powered by a rich array of online resources designed to deliver an all-in-one solution for learning and retaining the course topics. The following items are included in the MindTap learning path:

• A media-rich e-version of the text enhanced with Concept Clips (brief animated videos that describe and define key concepts) and Problem Walkthroughs (longer videos that demonstrate how to solve the most common problem types step by step).

• A comprehensive digital homework problem set designed to guide students from basic comprehension to real-world application of concepts and to facilitate preparation for exams. Practice problems, tutorials, and other learning modules are drawn from both Aplia and CNOW homework solutions.

• An MBA Refresher Module, including a pre-test, remediation, and a post-test, that provides those students who need it with a refresher of core concepts in Finance, Math/Algebra, Statistics, Accounting, and more.

• Group case activities designed to facilitate students working in teams to analyze short cases at a number of key points throughout the course.

• Practice quizzes to measure overall comprehension of chapter concepts.

CengageNOWTM for Corporate Finance: A Focused Approach Designed by instructors for instructors, CengageNOWTM mirrors your natural workflow and provides time-saving, performance-enhancing tools for you and your students—all in one program! CengageN- OWTM takes the best of current technology tools including online homework management and fully customizable algorithmic end-of-chapter problems and test bank to support your course goals and save you significant preparation and grading time!

• Plan student assignments with an easy online homework management component. • Manage your grade book with ease. • Teach today’s student using valuable course support materials. • Reinforce student comprehension with Personalized Study. • Test with customizable algorithmic end-of-chapter problems that provide students with

immediate feedback upon answer submission. • Grade automatically for seamless, immediate results.

Preface xiii

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ApliaTM Finance ApliaTM Finance, an interactive learning system, engages students in course concepts, ensures they practice on a regular basis, and helps them prepare to learn finance through a series of problems and tutorials. Created by an instructor to help students excel, book-specific problem sets have instant grades and detailed feedback, ensuring students have the opportunity to learn from and improve with every question.

Chapter assignments use the same language and tone of the course textbook, giving students a seamless experience in and out of the classroom. Problems are automatically graded and offer detailed explanations, helping students learn from every question.

ApliaTM Finance offers:

• Problem Sets: Chapter-specific problem sets ensure that students are completing finance assignments on a regular basis.

• Preparing for Finance Tutorials: Hands-on tutorials solve math, statistics, economics, and accounting roadblocks before they become a problem in the course, and financial calculator tutorials help students learn to use the tools needed in a finance course.

• Finance in Action: Exploratory modules help students understand how financial theories are applied in the real world, and how finance professionals synthesize, use, and apply financial information.

• Course Management System • MindTap Reader: Aplia now features Cengage’s premier e-book format. MindTap Reader is

highly interactive, allows for inline note-taking and highlighting, and features a variety of apps to further assist students.

For more information, visit www.aplia.com/finance.

Cengage Learning Custom Solutions Whether you need print, digital, or hybrid course materials, Cengage Learning Custom Solutions can help you create your perfect learning solution. Draw from Cengage Learning’s extensive library of texts and collections, add or create your own original work, and create customized media and technology to match your learning and course objectives. Our editorial team will work with you through each step, allowing you to concentrate on the most important thing—your students. Learn more about all of our custom services at www.cengage.com/custom.

The Cengage Global Economic Watch (GEW) Resource Center This is your source for turning today’s challenges into tomorrow’s solutions. This online portal houses the most up-to-date content concerning the economic crisis.

Organized by discipline, the GEW Resource Center offers the solutions instructors and students need in an easy-to-use format. Included are an overview and time line of the historical events leading up to the crisis, links to the latest news and resources, discussion and testing content, an instructor feedback forum, and a Global Issues Database. Visit www.cengage.com/thewatch for more information.

Acknowledgments This book reflects the efforts of a great many people over a number of years. In addition to our immediate colleagues, we appreciate very much the many helpful comments and suggestions we receive from professors who use our book in their classes. Professors Greg Faulk, Anthony Gu, Andrew Mose, Chee Ng, John Stieven, and Serge Wind have been especially helpful, providing many hints and tips for improving the learning points in our textbook.

Many professors and professionals who are experts on specific topics reviewed earlier versions of individual chapters or groups of chapters, and we are grateful for their insights; in addition, we would like to thank those whose reviews and comments on earlier editions and companion books have contributed to this edition:

xiv Preface

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Mike Adler Syed Ahmad Sadhana M. Alangar Ed Altman Mary Schary Amram Anne Anderson Bruce Anderson Ron Anderson Bob Angell Vince Apilado Henry Arnold Nasser Arshadi Bob Aubey Abdul Aziz Gil Babcock Peter Bacon Kent Baker Tom Bankston Les Barenbaum Charles Barngrover Michael Barry Bill Beedles Moshe Ben-Horim Omar M. Benkato Bill Beranek Tom Berry Bill Bertin Roger Bey Dalton Bigbee John Bildersee Rahul Bishnoi Eric Blazer Russ Boisjoly Keith Boles Gordon R. Bonner Geof Booth Kenneth Boudreaux Helen Bowers Oswald Bowlin Don Boyd G. Michael Boyd Pat Boyer Ben S. Branch Joe Brandt Elizabeth Brannigan Greg Brauer Mary Broske Dave Brown Kate Brown Bill Brueggeman Kirt Butler Robert Button Chris Buzzard Bill Campsey Bob Carleson Severin Carlson David Cary Steve Celec Don Chance Antony Chang Susan Chaplinsky Jay Choi S. K. Choudhury Lal Chugh Jonathan Clarke Maclyn Clouse Margaret Considine Phil Cooley Joe Copeland David Cordell John Cotner Charles Cox

David Crary John Crockett Roy Crum Brent Dalrymple Bill Damon Joel Dauten Steve Dawson Sankar De Miles Delano Fred Dellva Anand Desai Bernard Dill Greg Dimkoff Les Dlabay Mark Dorfman Gene Drycimski Dean Dudley David Durst Ed Dyl Dick Edelman Charles Edwards John Ellis Dave Ewert John Ezzell Richard Fendler Michael Ferri Jim Filkins John Finnerty Susan Fischer Mark Flannery Steven Flint Russ Fogler E. Bruce Frederickson Dan French Tina Galloway Partha Gangopadhyay Phil Gardial Michael Garlington Sharon H. Garrison Jim Garvin Adam Gehr Jim Gentry Stuart Gillan Philip Glasgo Rudyard Goode Myron Gordon Walt Goulet Bernie Grablowsky Theoharry

Grammatikos Ed Grossnickle John Groth Alan Grunewald Manak Gupta Sam Hadaway Don Hakala Janet Hamilton Sally Hamilton Gerald Hamsmith William Hardin John Harris Paul Hastings Patty Hatfield Bob Haugen Steve Hawke Del Hawley Hal Heaton Robert Hehre John Helmuth George Hettenhouse Hans Heymann Kendall Hill

Roger Hill Tom Hindelang Linda Hittle Ralph Hocking J. Ronald Hoffmeister Jim Horrigan John Houston John Howe Keith Howe Hugh Hunter Steve Isberg Jim Jackson Vahan Janjigian Kurt Jesswein Kose John Craig Johnson Keith Johnson Steve Johnson Ramon Johnson Ray Jones Manuel Jose Gus Kalogeras Mike Keenan Eric Kelley Bill Kennedy Joe Kiernan Robert Kieschnick Rick Kish Linda Klein Don Knight Dorothy Koehl Theodor Kohers Jaroslaw Komarynsky Duncan Kretovich Harold Krogh Charles Kroncke Lynn Phillips Kugele Joan Lamm P. Lange Howard Lanser Martin Laurence Ed Lawrence Richard LeCompte Wayne Lee Jim LePage Ilene Levin Jules Levine John Lewis James T. Lindley Chuck Linke Bill Lloyd Susan Long Judy Maese Bob Magee Ileen Malitz Phil Malone Terry Maness Chris Manning Terry Martell D. J. Masson John Mathys John McAlhany Andy McCollough Tom McCue Bill McDaniel Robin McLaughlin Jamshid Mehran Ilhan Meric Larry Merville Rick Meyer Stuart E. Michelson Jim Millar

Ed Miller John Mitchell Carol Moerdyk Bob Moore Hassan Moussawi Barry Morris Gene Morris Fred Morrissey Chris Muscarella Stu Myers David Nachman Tim Nantell Don Nast Bill Nelson Bob Nelson Bob Niendorf Tom O’Brien Dennis O’Connor John O’Donnell Jim Olsen Robert Olsen Frank O’Meara David Overbye R. Daniel Pace Coleen Pantalone Jim Pappas Stephen Parrish Pam Peterson Glenn Petry Jim Pettijohn Rich Pettit Dick Pettway Hugo Phillips John Pinkerton Gerald Pogue Ralph A. Pope R. Potter Franklin Potts R. Powell Chris Prestopino Jerry Prock Howard Puckett Herbert Quigley George Racette Bob Radcliffe Allen Rappaport Bill Rentz Ken Riener Charles Rini John Ritchie Jay Ritter Pietra Rivoli Fiona Robertson Antonio Rodriguez E. M. Roussakis Dexter Rowell Mike Ryngaert Jim Sachlis Abdul Sadik A. Jon Saxon Thomas Scampini Kevin Scanlon Frederick Schadler James Schallheim Mary Jane Scheuer Carl Schweser John Settle Alan Severn Sol Shalit Elizabeth Shields Frederic Shipley Dilip Shome

Ron Shrieves Neil Sicherman J. B. Silvers Clay Singleton Joe Sinkey Stacy Sirmans Jaye Smith Steve Smith Don Sorenson David Speairs Ken Stanly John Stansfield Ed Stendardi Alan Stephens Don Stevens Jerry Stevens G. Bennett Stewart Mark Stohs Glen Strasburg Robert Strong Philip Swensen Ernie Swift Paul Swink Eugene Swinnerton Robert Taggart Gary Tallman Dennis Tanner Craig Tapley Russ Taussig Richard Teweles Ted Teweles Andrew Thompson Jonathan Tiemann Sheridan Titman George Trivoli George Tsetsekos Alan L. Tucker Mel Tysseland David Upton Howard Van Auken Pretorious Van den Dool Pieter Vanderburg Paul Vanderheiden David Vang Jim Verbrugge Patrick Vincent Steve Vinson Susan Visscher Joseph Vu John Wachowicz Mark D. Walker Mike Walker Sam Weaver Kuo Chiang Wei Bill Welch Gary R. Wells Fred Weston Norm Williams Tony Wingler Ed Wolfe Larry Wolken Don Woods Thomas Wright Michael Yonan Zhong-guo Zhou David Ziebart Dennis Zocco, and Kent Zumwalt

Preface xv

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Special thanks are due to Dana Clark, Susan Whitman, Amelia Bell, and Kirsten Benson, who provided invaluable editorial support; to Joel Houston and Phillip Daves, whose work with us on other books is reflected in this text; and to Lou Gapenski, our past coauthor, for his many contributions.

Our colleagues and our students at the Universities of Florida and Tennessee gave us many useful suggestions, and the Cengage staff—especially Jennifer King, Jana Lewis, Mike Reynolds, Heather Mooney, and Brad Sullender—helped greatly with all phases of text development, produc- tion, and marketing.

Errors in the Text At this point, authors generally say something like this: “We appreciate all the help we received from the people listed above, but any remaining errors are, of course, our own responsibility.” And in many books, there are plenty of remaining errors. Having experienced difficulties with errors ourselves, both as students and as instructors, we resolved to avoid this problem in Corporate Finance. As a result of our error-detection procedures, we are convinced that the book is relatively free of mistakes.

Partly because of our confidence that few such errors remain, but primarily because we want to detect any errors in the textbook that may have slipped by so we can correct them in subsequent printings, we decided to offer a reward of $10 per error to the first person who reports a textbook error to us. For purposes of this reward, errors in the textbook are defined as misspelled words, nonrounding numerical errors, incorrect statements, and any other error that inhibits compre- hension. Typesetting problems such as irregular spacing and differences in opinion regarding grammatical or punctuation conventions do not qualify for this reward. Also, given the ever- changing nature of the Internet, changes in Web addresses do not qualify as errors, although we would appreciate reports of changed Web addresses. Finally, any qualifying error that has follow- through effects is counted as two errors only. Please report any errors to Michael C. Ehrhardt at the e-mail address given below.

Conclusion Finance is, in a real sense, the cornerstone of the free enterprise system. Good financial management is therefore vitally important to the economic health of business firms, hence to the nation and the world. Because of its importance, corporate finance should be thoroughly understood. However, this is easier said than done—the field is relatively complex, and it is undergoing constant change in response to shifts in economic conditions. All of this makes corporate finance stimulating and exciting, but also challenging and sometimes perplexing. We sincerely hope that Corporate Finance: A Focused Approach will help readers understand and solve the financial problems businesses face today.

Michael C. Ehrhardt Eugene F. Brigham University of Tennessee University of Florida Ehrhardt@utk.edu Gene.Brigham@cba.ufl.edu

November 2015

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PART 1

The Company and Its Environment

C H A P T E R 1 An Overview of Financial Management and the Financial Environment 3 C H A P T E R 2 Financial Statements, Cash Flow, and Taxes 57 C H A P T E R 3 Analysis of Financial Statements 101

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Copyright 2017 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.

C H A P T E R 1

An Overview of Financial Management and the Financial Environment

In a global beauty contest for companies, the winner is … Apple. Or at least Apple is the most admired company in the world, according to Fortune

magazine’s annual survey. The others in the global top ten are Amazon.com, Google, Berkshire Hathaway, Starbucks, Coca-Cola, Walt Disney, FedEx, Southwest Airlines, and General Electric. What do these companies have that separates them from the rest of the pack?

Based on a survey of executives, directors, and security analysts, these companies have very high average scores across nine attributes: (1) innovativeness, (2) quality of management, (3) long-term investment value, (4) social responsibility, (5) people management, (6) quality of products and services, (7) financial soundness, (8) use of corporate assets, and (9) effectiveness in doing business globally. After culling weaker companies, the final rankings are then determined by over 3,900 experts from a wide variety of industries.

What makes these companies special? In a nutshell, they reduce costs by having innovative production processes, they create value for customers by providing high- quality products and services, and they create value for employees by training and fostering an environment that allows employees to utilize all of their skills and talents. As you will see throughout this book, the resulting cash flow and superior return on capital also create value for investors.

3

w w w See http://fortune.com/ worlds-most-admired -companies for updates on the rankings.

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This chapter should give you an idea of what financial management is all about, including an overview of the financial markets in which corporations operate. Before going into details, let’s look at the big picture. You’re probably in school because you want an interesting, challenging, and rewarding career. To see where finance fits in, here’s a five-minute MBA.

1-1 The Five-Minute MBA Okay, we realize you can’t get an MBA in five minutes. But just as an artist quickly sketches the outline of a picture before filling in the details, we can sketch the key elements of an MBA education. The primary objective of an MBA program is to provide managers with the knowledge and skills they need to run successful companies, so we start our sketch with some common characteristics of successful companies.

First, successful companies have skilled people at all levels inside the company, includ- ing leaders, managers, and a capable workforce. Skilled people enable a company to identify, create, and deliver products or services that are highly valued by customers— so highly valued that customers choose to purchase from them rather than from their competitors.

Second, successful companies have strong relationships with groups outside the com- pany. For example, successful companies develop win–win relationships with suppliers and excel in customer relationship management.

Third, successful companies have enough funding to execute their plans and support their operations. Most companies need cash to purchase land, buildings, equipment, and materials. Companies can reinvest a portion of their earnings, but most growing compa- nies also must raise additional funds externally by some combination of selling stock and/ or borrowing in the financial markets. Therefore, all successful companies sell their products/services at prices that are high enough to cover costs and to compensate owners and creditors for the use of their money and their exposure to risk.

To help your company succeed, you must be able to evaluate any proposal or idea, whether it relates to marketing, supply chains, production, strategy, mergers, or any other area. In addition, you must understand the ways that value-adding proposals can be funded. Therefore, we will show you how to evaluate proposals and fund value-adding ideas, essential financial skills that will help you throughout your career.

S E L F - T E S T

What are three attributes of successful companies?

What two essential financial skills must every successful manager have?

1-2 Finance from 40,000 Feet Above Seeing the big picture of finance from a bird’s-eye view will help you keep track of the individual parts. It all starts with some individuals or organizations that have more cash than they presently want to spend. Other individuals or organizations have less cash than they currently want to spend, but they have opportunities to generate cash in the future.

Let’s call the two groups providers and users: The providers have extra cash today and the users have opportunities to generate cash in the future. For example, a provider might be an individual who is spending less today in order to save for retirement. Another provider might be a bank with more cash on hand than it needs. In either case, the provider is willing to give up cash today for cash in the future.

r e s o u r c e The textbook’s Web site has tools for teaching, learning, and conducting financial research.

4 Part 1 The Company and Its Environment

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A user might be a student who wants to borrow money for tuition and who plans to pay it back from future earnings after graduating. Another user might be an entrepreneur who has an idea for a new social media application that might generate cash in the future but requires cash today to pay for programmers.

Figure 1-1 shows the relationship between providers and users. As Figure 1-1 shows, providers supply cash now to users in exchange for a claim on

future cash flows. For example, if you took out a student loan, the bank gave you cash, but you signed a document giving the bank a claim on future cash flows to be paid from you to the bank. This claim is risky, because there is some probability (hopefully small) that you will not be able to repay the loan.

Two problems immediately present themselves. First, how do the providers and users identify one another and exchange cash now for claims on risky future cash? Second, how can potential providers evaluate the users’ opportunities? In other words, are the claims on risky future cash flows sufficient to compensate the providers for giving up their cash today? At the risk of oversimplification, financial markets are simply ways of connecting providers with users, and financial analysis is a tool to evaluate risky opportunities.

We cover many topics in this book, and it can be easy to miss the forest for the trees. So as you read about a particular topic, think about how the topic is related to the role played by financial markets in connecting providers with users or how the topic explains a tool for evaluating financial claims on risky future cash flows.

Later in this chapter we provide an overview of financial markets, but first we address an especially important type of user: companies that are incorporated.

S E L F - T E S T

What do providers supply? What do providers receive?

What do users receive? What do users offer?

What two problems are faced by providers and users?

1-3 The Corporate Life Cycle Many major corporations, including Apple and Hewlett-Packard, began life in a garage or basement. How is it possible for such companies to grow into the giants we see today? No two companies develop in exactly the same way, but the following sections describe some typical stages in the corporate life cycle.

FIGURE 1-1 Providers and Users: Cash Now versus Claims on Risky Future Cash

Provider:

Person or organization with cash now

Cash now

Claim on risky future cash

User:

Person or organization with opportunities to convert cash now into cash later

Chapter 1 An Overview of Financial Management and the Financial Environment 5

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1-3a Starting Up as a Proprietorship Many companies begin as a proprietorship, which is an unincorporated business owned by one individual. Starting a business as a proprietor is easy—one merely begins business operations after obtaining any required city or state business licenses. The proprietorship has three important advantages: (1) It is easily and inexpensively formed. (2) It is subject to few government regulations. (3) Its income is not subject to corporate taxation but is taxed as part of the proprietor’s personal income.

However, the proprietorship also has three important limitations: (1) It may be difficult for a proprietorship to obtain the funding needed for growth. (2) The proprietor has unlimited personal liability for the business’s debts, which can result in losses that exceed the money invested in the company. (Creditors may even be able to seize a proprietor’s house or other personal property!) (3) The life of a proprietorship is limited to the life of its founder. For these three reasons, sole proprietorships are used primarily for small businesses. In fact, proprietorships account for only about 4% of all sales, based on dollar values, even though about 72% of all companies are proprietorships.

1-3b More Than One Owner: A Partnership Some companies start with more than one owner, and some proprietors decide to add a partner as the business grows. A partnership exists whenever two or more persons or entities associate to conduct a noncorporate business for profit. Partnerships may operate under different degrees of formality, ranging from informal, oral understandings to formal agree- ments filed with the secretary of the state in which the partnership was formed. Partnership agreements define the ways any profits and losses are shared between partners. A partner- ship’s advantages and disadvantages are generally similar to those of a proprietorship.

Regarding liability, the partners potentially can lose all of their personal assets, even assets not invested in the business, because under partnership law, each partner is liable for the business’s debts. Therefore, in the event the partnership goes bankrupt, if any partner is unable to meet his or her pro rata liability then the remaining partners must make good on the unsatisfied claims, drawing on their personal assets to the extent necessary. To avoid this, it is possible to limit the liabilities of some of the partners by establishing a limited partnership, wherein certain partners are designated general partners and others limited partners. In a limited partnership, the limited partners can lose only the amount of their investment in the partnership, while the general partners have unlimited liability. However, the limited partners typically have no control—it rests solely with the general partners—and their returns are likewise limited. Limited partner- ships are common in real estate, oil, equipment-leasing ventures, and venture capital. However, they are not widely used in general business situations, because usually no partner is willing to be the general partner and thus accept the majority of the business’s risk, and no partners are willing to be limited partners and give up all control.

In both regular and limited partnerships, at least one partner is liable for the debts of the partnership. However, in a limited liability partnership (LLP) and a limited liability company (LLC), all partners (or members) enjoy limited liability with regard to the business’s liabilities, and their potential losses are limited to their investment in the LLP. Of course, this arrangement increases the risk faced by an LLP’s lenders, customers, and suppliers.

1-3c Many Owners: A Corporation Most partnerships have difficulty attracting substantial amounts of capital. This is generally not a problem for a slow-growing business, but if a business’s products or services really catch on, and if it needs to raise large sums of money to capitalize on its opportunities, then

6 Part 1 The Company and Its Environment

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the difficulty in attracting capital becomes a real drawback. Thus, many growth companies, such as Hewlett-Packard and Microsoft, began life as a proprietorship or partnership, and at some point their founders decided to convert to a corporation. On the other hand, some companies, in anticipation of growth, actually begin as corporations. A corporation is a legal entity created under state laws, and it is separate and distinct from its owners and managers. This separation gives the corporation three major advantages: (1) unlimited life— a corporation can continue after its original owners and managers are deceased; (2) easy transferability of ownership interest—ownership interests are divided into shares of stock, which can be transferred far more easily than can proprietorship or partnership interests; and (3) limited liability—losses are limited to the actual funds invested.

To illustrate limited liability, suppose you invested $10,000 in a partnership that then went bankrupt and owed $1 million. Because the owners are liable for the debts of a partnership, you could be assessed for a share of the company’s debt, and you could be held liable for the entire $1 million if your partners could not pay their shares. On the other hand, if you invested $10,000 in the stock of a corporation that went bankrupt, your potential loss on the investment would be limited to your $10,000 investment. Unlimited life, easy transferability of ownership interest, and limited liability make it much easier for corporations than proprietorships or partnerships to raise money in the financial markets and grow into large companies.

The corporate form offers significant advantages over proprietorships and partner- ships, but it also has two disadvantages: (1) Corporate earnings may be subject to double taxation—the earnings of the corporation are taxed at the corporate level, and then earnings paid out as dividends are taxed again as income to the stockholders. (2) Setting up a corporation involves preparing a charter, writing a set of bylaws, and filing the many required state and federal reports, which is more complex and time-consuming than creating a proprietorship or a partnership.

The charter includes the following information: (1) name of the proposed corporation, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of directors, and (5) names and addresses of directors. The charter is filed with the secretary of the state in which the firm will be incorporated, and when it is approved, the corporation is officially in existence.1 After the corporation begins operating, quarterly and annual employment, financial, and tax reports must be filed with state and federal authorities.

The bylaws are a set of rules drawn up by the founders of the corporation. Included are such points as: (1) how directors are to be elected (all elected each year or perhaps one-third each year for 3-year terms), (2) whether the existing stockholders will have the first right to buy any new shares the firm issues, and (3) procedures for changing the bylaws themselves, should conditions require it.

There are several different types of corporations. Professionals such as doctors, lawyers, and accountants often form a professional corporation (PC) or a professional association (PA). These types of corporations do not relieve the participants of professional (malpractice) liability. Indeed, the primary motivation behind the professional corporation was to provide a way for groups of professionals to incorporate in order to avoid certain types of unlimited liability yet still be held responsible for professional liability.

Finally, if certain requirements are met, particularly with regard to size and number of stockholders, owners can establish a corporation but elect to be taxed as if the business were a proprietorship or partnership. Such firms, which differ not in organizational form but only in how their owners are taxed, are called S corporations.

1More than 60% of major U.S. corporations are chartered in Delaware, which has, over the years, provided a favorable legal environment for corporations. It is not necessary for a firm to be headquartered, or even to conduct operations, in its state of incorporation, or even in its country of incorporation.

Chapter 1 An Overview of Financial Management and the Financial Environment 7

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