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Foundations of Finance The Logic and Practice of Financial Management

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Foundations of Finance The Logic and Practice of Financial Management

Eighth Edition

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

Keown, Arthur J. Foundations of finance : the logic and practice of financial management / Arthur J. Keown, John D. Martin, J. William Petty. — 8th ed. p. cm. — (The Pearson series in finance) Includes index. ISBN 978-0-13-299487-3 1. Corporations—Finance. I. Martin, John D., II. Petty, J. William, III. Title. HG4026.F67 2014 658.15--dc23

2012041146

Copyright © 2014, 2011, 2008, Pearson Education, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. For information on obtaining permission for use of material in this work, please submit a written request to Pearson Education, Inc., Permissions Department, One Lake Street, Upper Saddle River, New Jersey 07458, or you may fax your request to 201-236-3290.

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www.pearsonhighered.com ISBN-13: 978-0-13-299487-3

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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 Martin boys—grandsons Luke and Burke.

John D. Martin

To my wife, Donna, who has been my friend, encourager, and supporter for more years than we care to admit. How quickly time has passed

since we first met all the way back in high school. J. William Petty

vi Part 1 • Financial Planning

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 doctor- ate 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 Excel- lence Award; and in 1999 received the Outstanding Faculty Award from the State of Vir- ginia. Professor Keown is widely published in academic journals. His work has appeared in the Journal of Finance, the Journal of Financial Economics, the Journal of Financial and Quantitative Analysis, the Journal of Financial Research, the Journal of Banking and Finance, Financial Management, the Journal of Portfolio Management, and many others. In addition to Foundations of Finance, two other 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 recently 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 and two children 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 teaches in the Baylor EMBA programs and has three times been selected as the outstanding teacher. John 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 journals, including papers in the Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analy- sis, Journal of Monetary Economics, and Management Science. His recent research has spanned issues related to the economics of unconventional energy sources (both wind and shale gas), the hidden cost of venture capital, and managed versus unmanaged changes in capital struc- tures. He is also co-author of several books, including Financial Management: Principles and Practice (11th ed., Prentice Hall), Foundations of Finance (8th ed., Prentice Hall), Theory of Finance (Dryden Press), Financial Analysis (3rd ed., McGraw Hill), Valuation: The Art & Sci- ence of Corporate Investment Decisions (2nd ed., Prentice Hall), and Value Based Management with Social Responsibility (2nd ed., Oxford University Press).

J. William Petty, PhD, University of Texas at Austin, is Professor of Finance and W. W. Caruth Chair of Entrepreneurship. Dr. Petty teaches entrepreneurial finance, both at the undergraduate and graduate levels. He is a University Master Teacher. In 2008, the Acton Foundation for Entrepreneurship Excellence selected him as the National Entrepre- neurship Teacher of the Year. His research interests include the financing of entrepreneur- ial 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 Finan- cial and Quantitative Analysis, Financial Management, Journal of Portfolio Management, Jour- nal 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 has served as the Executive Director of the Baylor Angel Network, a network of private investors who provide capital to startups and early-stage companies.

About the Authors

vi

Chapter 4 • Tax Planning and Strategies vii

vii

Brief Contents

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 20 3 Understanding Financial Statements and Cash Flows 50 4 Evaluating a Firm’s Financial Performance 102

Part 2 The Valuation of Financial Assets 142 5 The Time Value of Money 142 6 The Meaning and Measurement of Risk and Return 182 7 The Valuation and Characteristics of Bonds 220 8 The Valuation and Characteristics of Stock 250 9 The Cost of Capital 274

Part 3 Investment in Long-Term Assets 304 10 Capital-Budgeting Techniques and Practice 304 11 Cash Flows and Other Topics in Capital Budgeting 344

Part 4 Capital Structure and Dividend Policy 380 12 Determining the Financing Mix 380 13 Dividend Policy and Internal Financing 416

Part 5 Working-Capital Management and International Business Finance 436

14 Short-Term Financial Planning 436 15 Working-Capital Management 456 16 International Business Finance 484 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 505

Indexes 513

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ix

Contents Preface xix

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 7 The Current Global Financial Crisis 8 Avoiding Financial Crisis—Back to the Principles 9 The Essential Elements of Ethics and Trust 10

The Role of Finance in Business 11

Why Study Finance? 11 The Role of the Financial Manager 12

The Legal Forms of Business Organization 13

Sole Proprietorships 13 Partnerships 13 Corporations 14 Organizational Form and Taxes: The Double Taxation on Dividends 14 S-Corporations and Limited Liability Companies (LLC) 14 Which Organizational Form Should Be Chosen? 15

Finance and the Multinational Firm: The New Role 15

Chapter Summaries 16 • Review Questions 18 • Mini Case 18

2 The Financial Markets and Interest Rates 20 Financing of Business: The Movement of Funds Through the Economy 21

Public Offerings Versus Private Placements 23 Primary Markets Versus Secondary Markets 23 The Money Market Versus the Capital Market 24 Spot Markets Versus Futures Markets 24 Stock Exchanges: Organized Security Exchanges Versus Over-the-Counter Markets,

a Blurring Difference 25

Selling Securities to the Public 26

Functions 27 The Demise of the Stand-Alone Investment-Banking Industry 27 Distribution Methods 28 Private Debt Placements 30 Flotation Costs 31

Cautionary Tale: Forgetting Principle 5: Conflicts of Interest Cause Agency Problems 31

Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley Act 32

Rates of Return in the Financial Markets 32

Rates of Return over Long Periods 32 Interest Rate Levels in Recent Periods 33

x Contents

Interest Rate Determinants in a Nutshell 36

Estimating Specific Interest Rates Using Risk Premiums 36 Real Risk-Free Interest Rate and the Risk-Free Interest Rate 37 Real and Nominal Rates of Interest 37

Can You Do It? 37

Did You Get It? 38

Inflation and Real Rates of Return: The Financial Analyst’s Approach 39

Can You Do It? Solving for the Real Rate of Interest 39

Did You Get It? Solving for the Real Rate of Interest 40

The Term Structure of Interest Rates 41 Observing the Historical Term Structures of Interest Rates 41

Can You Do It? Solving for the Nominal Rate of Interest 41

Did You Get It? Solving for the Nominal Rate of Interest 42

What Explains the Shape of the Term Structure? 43

Chapter Summaries 44 • Review Questions 47 • Study Problems 47 • Mini Case 49

3 Understanding Financial Statements and Cash Flows 50 The Income Statement 52

Income Statement Illustrated: The Home Depot, Inc. 53 Home Depot’s Common-Sized Income Statement 54

The Balance Sheet 56

Types of Assets 57 Types of Financing 59 Balance Sheet Illustrated: The Home Depot, Inc. 60 Working Capital 62 The Balance Sheet and Income Statement—as One Picture 64

Can You Do It? Preparing an Income Statement and a Balance Sheet 65

Measuring Cash Flows 65

Profits Versus Cash Flows 65

Did You Get It? Preparing an Income Statement and a Balance Sheet 66

A Beginning Look: Determining Sources and Uses of Cash 67 Statement of Cash Flows 67

Finance at Work: Managing Your Cash Flows 68

Concluding Suggestions for Computing Cash Flows 74 Conclusions About Home Depot’s Financial Position 74

Finance at Work: What Did Home Depot’s Management Have to Say? 75

Can You Do It? Measuring Cash Flows 75

GAAP and IFRS 76

Did You Get It? Measuring Cash Flows 76

Income Taxes and Finance 76

Computing Taxable Income 77 Computing the Taxes Owed 77

Can You Do It? Computing a Corporation’s Income Taxes 79

Accounting Malpractice and Limitations of Financial Statements 80

Did You Get It? Computing a Corporation’s Income Taxes 80

Chapter Summaries 81 • Review Questions 84 • Study Problems 85 • Mini Case 92

Contents xi

Appendix 3A: Free Cash Flows 95 What Is a Free Cash Flow? 95

Computing Free Cash Flow 95

The Other Side of the Coin: Financing Cash Flows 98

Financing Cash Flows 98

A Concluding Thought 99

Appendix Summary 99 • Study Problems 99

4 Evaluating a Firm’s Financial Performance 102 The Purpose of Financial Analysis 102

Finance at Work: Home Depot and Lowe’s: The Histories 105

Measuring Key Financial Relationships 106

Question 1: How Liquid Is the Firm? Can It Pay Its Bills? 107 Question 2: Are the Firm’s Managers Generating Adequate Operating Profits from the

Company’s Assets? 112 Question 3: How Is the Firm Financing Its Assets? 117 Question 4: Are the Firm’s Managers Providing a Good Return on the Capital Provided by

the Shareholders? 119 Question 5: Are the Firm’s Managers Creating Shareholder Value? 122

The Limitations of Financial Ratio Analysis 128

Chapter Summaries 129 • Review Questions 132 • Study Problems 132 • Mini Case 139

Part 2 The Valuation of Financial Assets 142

5 The Time Value of Money 142 Compound Interest, Future, and Present Value 143

Using Timelines to Visualize Cash Flows 143 Techniques for Moving Money Through Time 147 Two Additional Types of Time Value of Money Problems 151 Applying Compounding to Things Other Than Money 152 Present Value 153

Cautionary Tale: Forgetting Principle 4: Market Prices Are Generally Right 155

Can You Do It? Solving for the Present Value with Two Flows in Different Years 156

Annuities 157

Compound Annuities 157

Did You Get It? Solving for the Present Value with Two Flows in Different Years 158

The Present Value of an Annuity 159 Annuities Due 161 Amortized Loans 162

Making Interest Rates Comparable 165

Finding Present and Future Values with Nonannual Periods 166

Can You Do It? How Much Can You Afford to Spend on a House? An Amortized Loan with Monthly Payments 166

Did You Get It? How Much Can You Afford to Spend on a House? An Amortized Loan with Monthly Payments 168

The Present Value of an Uneven Stream and Perpetuities 169

Perpetuities 170

Chapter Summaries 171 • Review Questions 174 • Study Problems 174 • Mini Case 180

xii Contents

6 The Meaning and Measurement of Risk and Return 182 Expected Return Defined and Measured 184

Can You Do It? Computing Expected Cash Flow and Expected Return 185

Risk Defined and Measured 186

Did You Get It? Computing Expected Cash Flow and Expected Return 187

Can You Do It? Computing the Standard Deviation 190

Finance at Work: A Different Perspective of Risk 190

Did You Get It? Computing the Standard Deviation 193

Rates of Return: The Investor’s Experience 193

Risk and Diversification 194

Diversifying Away the Risk 195 Measuring Market Risk 196

Can You Do It? Estimating Beta 199

Measuring a Portfolio’s Beta 202 Risk and Diversification Demonstrated 203

Did You Get It? Estimating Beta 204

The Investor’s Required Rate of Return 206

The Required Rate of Return Concept 206 Measuring the Required Rate of Return 206

Finance at Work: Does Beta Always Work? 207

Can You Do It? Computing a Required Rate of Return 209

Did You Get It? Computing a Required Rate of Return 209

Chapter Summaries 209 • Review Questions 212 • Study Problems 213 • Mini Case 217

7 The Valuation and Characteristics of Bonds 220 Types of Bonds 221

Debentures 221 Subordinated Debentures 222 Mortgage Bonds 222 Eurobonds 222 Convertible Bonds 222

Terminology and Characteristics of Bonds 223

Claims on Assets and Income 223 Par Value 223 Coupon Interest Rate 223 Maturity 224 Call Provision 224 Indenture 224 Bond Ratings 224

Finance at Work: J.C. Penney Credit Rating Reduced to Junk 225

Defining Value 226

What Determines Value? 227

Valuation: The Basic Process 228

Can You Do It? Computing an Asset’s Value 229

Valuing Bonds 229

Did You Get It? Computing an Asset’s Value 231

Can You Do It? Computing a Bond’s Value 233

Contents xiii

Did You Get It? Computing a Bond’s Value 235

Bond Yields 235

Yield to Maturity 235 Current Yield 237

Bond Valuation: Three Important Relationships 238

Can You Do It? Computing the Yield to Maturity and Current Yield 239

Did You Get It? Computing the Yield to Maturity and Current Yield 240

Chapter Summaries 242 • Review Questions 246 • Study Problems 246 • Mini Case 248

8 The Valuation and Characteristics of Stock 250 Preferred Stock 251

The Characteristics of Preferred Stock 251

Valuing Preferred Stock 253

Finance at Work: Reading a Stock Quote in the wall street journal 254

Can You Do It? Valuing Preferred Stock 256

Common Stock 256

The Characteristics of Common Stock 257

Did You Get It? Valuing Preferred Stock 257

Valuing Common Stock 258

Can You Do It? Measuring Johnson & Johnson’s Growth Rate 261

Did You Get It? Measuring Johnson & Johnson’s Growth Rate 262