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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.

Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps.

1 2 3 4 5 6 7 8 9 10

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

ISBN-10: 0-13-299487-9

www.pearsonhighered.com
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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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

Can You Do It? Calculating Common Stock Value 263

The Expected Rate of Return of Stockholders 263

Did You Get It? Calculating Common Stock Value 264

The Expected Rate of Return of Preferred Stockholders 264 The Expected Rate of Return of Common Stockholders 265

Can You Do It? Computing the Expected Rate of Return 266

Did You Get It? Computing the Expected Rate of Return 267

Chapter Summaries 268 • Review Questions 271 • Study Problems 271 • Mini Case 273

9 The Cost of Capital 274 The Cost of Capital: Key Definitions and Concepts 275

Opportunity Costs, Required Rates of Return, and the Cost of Capital 275

Can You Do It? Determining How Flotation Costs Affect the Cost of Capital 276

The Firm’s Financial Policy and the Cost of Capital 276

Determining the Costs of the Individual Sources of Capital 276

The Cost of Debt 277

Did You Get It? Determining How Flotation Costs Affect the Cost of Capital 277

Can You Do It? Calculating the Cost of Debt Financing 278

The Cost of Preferred Stock 279

Can You Do It? Calculating the Cost of Preferred Stock Financing 279

Did You Get It? Calculating the Cost of Debt Financing 280

The Cost of Common Equity 281 The Dividend Growth Model 281

xiv Contents

Did You Get It? Calculating the Cost of Preferred Stock Financing 281

Issues in Implementing the Dividend Growth Model 282 The Capital Asset Pricing Model 283

Can You Do It? Calculating the Cost of New Common Stock Using the Dividend Growth Model 284

Can You Do It? Calculating the Cost of Common Stock Using the CAPM 284

Issues in Implementing the CAPM 284

Finance at Work: IPOs: Should a Firm Go Public? 285

Did You Get It? Calculating the Cost of New Common Stock Using the Dividend Growth Model 285

Did You Get It? Calculating the Cost of Common Stock Using the CAPM 286

The Weighted Average Cost of Capital 286

Capital Structure Weights 287 Calculating the Weighted Average Cost of Capital 287

Cautionary Tale: Forgetting Principle 3: Risk Requires a Reward 289

Calculating Divisional Costs of Capital 290

Estimating Divisional Costs of Capital 290 Using Pure Play Firms to Estimate Divisional WACCs 290

Finance at Work: The Pillsbury Company Adopts Eva with a Grassroots Education Program 293

Can You Do It? Calculating the Weighted Average Cost of Capital 293

Did You Get It? Calculating the Weighted Average Cost of Capital 293

Using a Firm’s Cost of Capital to Evaluate New Capital Investments 294

Chapter Summaries 295 • Review Questions 297 • Study Problems 298 • Mini Cases 302

Part 3 Investment in Long-Term Assets 304

10 Capital-Budgeting Techniques and Practice 304 Finding Profitable Projects 305

Cautionary Tale: Forgetting Principle 3: Risk Requires a Reward and Principle 4: Market Prices Are Generally Right 306

Capital-Budgeting Decision Criteria 307

The Payback Period 307 The Net Present Value 310 Using Spreadsheets to Calculate the Net Present Value 312

Can You Do It? Determining the Npv of a Project 313 The Profitability Index (Benefit–Cost Ratio) 313

Did You Get It? Determining the Npv of a Project 314 The Internal Rate of Return 316

Can You Do It? Determining the IRR of a Project 318 Viewing the Npv–IRR Relationship: The Net Present Value Profile 319

Did You Get It? Determining the IRR of a Project 319 Complications with the IRR: Multiple Rates of Return 320 The Modified Internal Rate of Return (MIRR)2 321 Using Spreadsheets to Calculate the MIRR 324

Capital Rationing 325

The Rationale for Capital Rationing 325 Capital Rationing and Project Selection 326

Ranking Mutually Exclusive Projects 326

The Size-Disparity Problem 327 The Time-Disparity Problem 328 The Unequal-Lives Problem 329

Contents xv

Ethics in Financial Management: The Financial Downside of Poor Ethical Behavior 332

Chapter Summaries 332 • Review Questions 335 • Study Problems 336 • Mini Case 342

11 Cash Flows and Other Topics in Capital Budgeting 344 Guidelines for Capital Budgeting 345

Use Free Cash Flows Rather Than Accounting Profits 345 Think Incrementally 345 Beware of Cash Flows Diverted from Existing Products 345 Look for Incidental or Synergistic Effects 346 Work in Working-Capital Requirements 346 Consider Incremental Expenses 346 Remember That Sunk Costs Are Not Incremental Cash Flows 347 Account for Opportunity Costs 347 Decide If Overhead Costs Are Truly Incremental Cash Flows 347 Ignore Interest Payments and Financing Flows 347

Finance at Work: Universal Studios 348

Calculating a Project’s Free Cash Flows 348

What Goes into the Initial Outlay 348 What Goes into the Annual Free Cash Flows Over the Project’s Life 349 What Goes into the Terminal Cash Flow 350 Calculating the Free Cash Flows 350 A Comprehensive Example: Calculating Free Cash Flows 354

Can You Do It? Calculating Operating Cash Flows 355

Did You Get It? Calculating Operating Cash Flows 357

Can You Do It? Calculating Free Cash Flows 357

Options in Capital Budgeting 358

The Option to Delay a Project 358

Did You Get It? Calculating Free Cash Flows 358

The Option to Expand a Project 359 The Option to Abandon a Project 359 Options in Capital Budgeting: The Bottom Line 360

Risk and the Investment Decisions 360

What Measure of Risk Is Relevant in Capital Budgeting? 361 Measuring Risk for Capital-Budgeting Purposes with a Dose of Reality—Is Systematic

Risk All There Is? 362 Incorporating Risk into Capital Budgeting 362 Risk-Adjusted Discount Rates 363 Measuring a Project’s Systematic Risk 365 Using Accounting Data to Estimate a Project’s Beta 365 The Pure Play Method for Estimating Beta 366 Examining a Project’s Risk Through Simulation 366 Conducting a Sensitivity Analysis Through Simulation 368

Chapter Summaries 369 • Review Questions 371 • Study Problems 371 • Mini Case 376

Appendix 11A: The Modified Accelerated Cost of Recovery System 378 What Does All This Mean? 379

Study Problems 379

Part 4 Capital Structure and Dividend Policy 380

12 Determining the Financing Mix 380 Understanding the Difference Between Business and Financial Risk 382

Business Risk 382 Operating Risk 383

xvi Contents

Break-Even Analysis 383

Essential Elements of the Break-Even Model 383 Finding the Break-Even Point 385 The Break-Even Point in Sales Dollars 386

Can You Do It? Analyzing the Break-Even Sales Level 387

Did You Get It? Analyzing the Break-Even Sales Level 388

Sources of Operating Leverage 388

Can You Do It? Analyzing the Effects of Operating Leverage 388

Did You Get It? Analyzing the Effects of Operating Leverage 389

Can You Do It? Analyzing the Effects of Financial Leverage 389

Did You Get It? Analyzing the Effects of Financial Leverage 390

Financial Leverage 390 Combining Operating and Financial Leverage 391

Can You Do It? Analyzing the Combined Effects of Operating and Financial Leverage 392

Did You Get It? Analyzing the Combined Effects of Operating and Financial Leverage 392

Finance at Work: When Financial Leverage Proves to Be Too Much to Handle 393

Capital Structure Theory 393

Cautionary Tale: Forgetting Principle 3: Risk Requires a Reward 395

A Quick Look at Capital Structure Theory 395 The Importance of Capital Structure 396 Independence Position 396 The Moderate Position 397 Firm Value and Agency Costs 400 Agency Costs, Free Cash Flow, and Capital Structure 401 Managerial Implications 402

The Basic Tools of Capital Structure Management 402

EBIT-EPS Analysis 402 Comparative Leverage Ratios 405 Industry Norms 406 A Glance at Actual Capital Structure Management 406

Finance at Work: Capital Structures Around the World 407

Chapter Summaries 408 • Review Questions 411 • Study Problems 412 • Mini Cases 414

13 Dividend Policy and Internal Financing 416 Key Terms 417

Does Dividend Policy Matter to Stockholders? 418

Three Basic Views 418 Making Sense of Dividend Policy Theory 420 What Are We to Conclude? 423

The Dividend Decision in Practice 424

Legal Restrictions 424 Liquidity Constraints 424 Earnings Predictability 424 Maintaining Ownership Control 424 Alternative Dividend Policies 424 Dividend Payment Procedures 425

Stock Dividends and Stock Splits 426

Stock Repurchases 427

A Share Repurchase as a Dividend Decision 427 The Investor’s Choice 428

Contents xvii

Finance at Work: Companies Increasingly Use Share Repurchases to Distribute Cash to Their Stockholders 429

A Financing or Investment Decision? 429 Practical Considerations—The Stock Repurchase Procedure 429

Chapter Summaries 430 • Review Questions 432 • Study Problems 432 • Mini Case 435

Part 5 Working-Capital Management and International Business Finance 436

14 Short-Term Financial Planning 436 Financial Forecasting 437

The Sales Forecast 437 Forecasting Financial Variables 437 The Percent of Sales Method of Financial Forecasting 438 Analyzing the Effects of Profitability and Dividend Policy on DFN 439 Analyzing the Effects of Sales Growth on a Firm’s DFN 440

Can You Do It? Percent of Sales Forecasting 441

Did You Get It? Percent of Sales Forecasting 442

Limitations of the Percent of Sales Forecasting Method 443

Constructing and Using a Cash Budget 444

Budget Functions 444

Ethics in Financial Management: To Bribe or Not to Bribe 445

The Cash Budget 445

Ethics in Financial Management: Being Honest About the Uncertainty of the Future 446

Chapter Summaries 447 • Review Questions 448 • Study Problems 449 • Mini Case 454

15 Working-Capital Management 456 Managing Current Assets and Liabilities 457

The Risk–Return Trade-Off 457 The Advantages of Current Liabilities: Return 458 The Disadvantages of Current Liabilities: Risk 458

Determining the Appropriate Level of Working Capital 459

The Hedging Principles 459 Permanent and Temporary Assets 459 Temporary, Permanent, and Spontaneous Sources of Financing 460 The Hedging Principle: A Graphic Illustration 460

Cautionary Tale: Forgetting Principle 3: Risk Requires a Reward 460

The Cash Conversion Cycle 462

Can You Do It? Computing the Cash Conversion Cycle 462

Did You Get It? Computing the Cash Conversion Cycle 463

Estimating the Cost of Short-Term Credit Using the Approximate Cost-of-Credit Formula 464

Can You Do It? The Approximate Cost of Short-Term Credit 466

Sources of Short-Term Credit 466

Did You Get It? The Approximate Cost of Short-Term Credit 466

Finance at Work: Managing Working Capital by Trimming Receivables 467

Unsecured Sources: Accrued Wages and Taxes 467

xviii Contents

Can You Do It? The Cost of Short-Term Credit (Considering Compounding Effects) 468

Unsecured Sources: Trade Credit 468

Did You Get It? The Cost of Short-Term Credit (Considering Compounding Effects) 469

Unsecured Sources: Bank Credit 469 Unsecured Sources: Commercial Paper 471 Secured Sources: Accounts-Receivable Loans 473 Secured Sources: Inventory Loans 475

Chapter Summaries 476 • Review Questions 479 • Study Problems 479

16 International Business Finance 484 The Globalization of Product and Financial Markets 485

Foreign Exchange Markets and Currency Exchange Rates 486

Foreign Exchange Rates 487 Exchange Rates and Arbitrage 489 Asked and Bid Rates 489 Cross Rates 489

Can You Do It? Using the Spot Rate to Calculate a Foreign Currency Payment 489

Types of Foreign Exchange Transactions 490

Did You Get It? Using the Spot Rate to Calculate a Foreign Currency Payment 491

Exchange Rate Risk 492

Can You Do It? Computing a Percent-per-Annum Premium 492

Did You Get It? Computing a Percent-per-Annum Premium 493

Interest Rate Parity 494

Purchasing-Power Parity and the Law of One Price 495

The International Fisher Effect 496

Capital Budgeting for Direct Foreign Investment 497

Foreign Investment Risks 497

Chapter Summaries 498 • Review Questions 500 • Study Problems 501 • Mini Case 502

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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Preface 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, are trying to do the same thing. That is, we have tried to present financial management to students in a way that makes their studies as easy and productive as possible by using a step-by-step approach to walking them through each new concept or problem.

We are very proud of the history of this volume, as it was the first “shortened book” of financial management when it was published in its first edition. The book broke new ground by reducing the number of chapters down to the foundational materials and by try- ing to present the subject in understandable terms. We continue our quest for readability with the Eighth Edition.

Pedagogy That Works This book provides students with a conceptual understanding of the financial decision- making process, rather than just an introduction to 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 in- stead on memorizing formulas and proce- dures. As a result, students have a difficult time understanding the interrelationships among the topics covered. Moreover, later in life when the problems encountered do not match the textbook presentation, stu- dents may find themselves unprepared to abstract from what they learned. To over- come this problem, the opening chapter presents five underlying principles of fi- nance, which serve as a springboard for the chapters and topics that follow. In essence, the student is presented with a cohesive, interrelated perspective from which future problems can be approached.

With a focus on the big picture, we provide an introduction to financial deci- sion making rooted in current financial theory and in the current state of world economic conditions. This focus is perhaps most apparent in the attention given to the capital mar- kets and their influence on corporate financial decisions. What results is an introductory treatment of a discipline rather than the treatment of a series of isolated problems that face the financial manager. The goal of this text is not merely to teach the tools of a discipline or trade but also to enable students to abstract what is learned to new and yet unforeseen problems—in short, to educate the student in finance.

Innovations and Distinctive Features in the Eighth Edition NEW! A Multistep Approach to Problem Solving and Analysis As anyone who has taught the core undergraduate finance course knows, there is a wide range of math comprehension and skill. Students who do not have the math skills needed

4 Part 1 • The Scope and Environment of Financial Management

Obviously, there are some serious practical problems in using changes in 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 simply 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 com- plexities and complications of the real-world risk. As we follow this goal throughout our discussions, 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 un- related decision rules. This could not be further from the truth. In fact, our decision rules, and the logic that underlies them, spring from five simple principles 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 stockholders).

As you will see, while it is not necessary to understand finance to understand these principles, it is necessary to understand these principles in order to understand finance. Although these principles may at first appear simple or even trivial, they provide the driving force behind all that follows, weaving together the concepts and techniques presented in this text, and thereby allowing us to focus on the logic underlying 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 dra- matically 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 billion worldwide, actually lost $167 million according to the accountants. Was Harry Potter and the Order of the Phoenix a successful movie? It sure was—in fact it was the 16th highest grossing film of all time. Without question, it produced cash, but it didn’t make any profits.

There is another important point we need to make about cash flows. Recall from your economics classes that we should always look at marginal, or incremental, cash flows when making a financial decision. The incremental cash flow to the company as a whole is the difference between the cash flows the company will produce both with and without the investment it’s thinking about making. To understand this concept, let’s think about the incremental cash flows of the Pirates of the Caribbean movies. Not only did Disney make money on the

1 rinciple

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

incremental cash flow the difference between the cash flows a company will produce both with and without the investment it is thinking about making.

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xx Preface

to master the subject sometimes end up memorizing formulas rather than focusing on the analysis of business decisions using math as a tool. We address this problem both in terms of text content and pedagogy.

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

● Second, finance is an analytical subject and requires that students be able to solve prob- lems. To help with this process, numbered chapter examples appear throughout the book. Each of these examples follows a very detailed and multistep approach to prob- lem solving that helps students develop their problem-solving skills.

Step 1: Formulate a Solution Strategy. For example, what is the appropriate formula 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 first present a description of the solution in prose and then a correspond- ing 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 mak- ing. 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.

NEW! Financial Decision Tools This feature recaps keys equations shortly after their application in the chapter.

NEW! Chapter Summaries These have been rewritten to make it easier for students to connect the summary with each of the in-chapter sections and learning objectives.

NEW! Key Terms List for Each Chapter New terminology introduced in the chapter is listed along with a brief definition.

NEW! Study Problems The end-of-chapter study problems have been improved and dramatically expanded to al- low for a wider range of student practice. In addition, the study problems are now organized according to learning objective so that both the instructor and student can readily align text and problem materials.

NEW! 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 have revised this edition to reinforce this focus in the content and organization of our text in some very concrete ways:

● We build our discussion around five finance principles that provide the foundation for the valuation of any investment.

● New topics are introduced in the context of “what is the value proposition?” and “how is the value of the enterprise affected?”

110 Part 1 • The Scope and Environment of Financial Management

As we did with days in receivables and accounts receivable turnover, we can restate days in inventory as inventory turnover, which is calculated as follows:6

Name of Tool Formula What It Tells You

Current ratio current assets

current liabilities Measures a firm’s liquidity. A higher ratio means greater liquidity.

Acid-test ratio cash + accounts receivable current liabilities

Gives a more stringent measure of liquidity than the cur- rent ratio in that it excludes inventories and other current assets from the numerator. A higher ratio means greater liquidity.

Days in receivables accounts receivable annual credit sales , 365

Indicates how rapidly a firm is collecting its receivables. A longer (shorter) period means a slower (faster) collection of receivables and that the receivables are of lesser (greater) quality.

Accounts receivable turnover annual credit sales accounts receivable

Tells how many times a firm’s accounts receivable are collected, or turned over, during a year. Provides the same information as the days in receivables, just expressed differently, where a high (low) number indicates slow (fast) collections.

Days in inventory inventory

cost of goods sold , 365

Measures how many days a firm’s inventories are held on average before being sold; the more (less) days required, the lower (higher) the quality of the inventory.

Inventory turnover cost of goods sold

inventory

Gives the number of times a firm’s inventory is sold and replaced during the year; as with days in inventory, serves as an indicator of the quality of the inventories; the higher the number, the better the inventory quality.

Financial Decision tools

inventory turnover a firm’s cost of goods sold divided by its inventory. This ratio measures the number of times a firm’s inventories are sold and replaced during the year, that is, the relative liquidity of the inventories.

6However, some of the industry norms provided by financial services are computed using sales in the numerator of inven- tory turnover. To make comparisons with ratios from these services, we will want to use sales in our computation of inventory turnover.

Inventory turnover = cost of goods sold

inventory (4-6)

For Home Depot:

Inventory turnover = $44,693M $10,625M

= 4.21X

Lowe’s inventory turnover 3.81X

Hence, we see that Home Depot is moving (turning over) its inventory more quickly than Lowe’s—4.21 times per year, compared with 3.81 times for Lowe’s. This suggests that Home Depot’s inventory is more liquid than Lowe’s.

To conclude, the current ratio indicates that Home Depot is less liquid than Lowe’s, but this result assumes that Home Depot’s accounts receivable and inventory are of similar quality to Lowe’s. However, this is not the case given Home Depot’s lower accounts receivable turn- over (more days in receivables) and higher inventory turnover (fewer days in inventory). The acid-test ratio, on the other hand, suggests that Home Depot is more liquid than Lowe’s, but we know that Home Depot’s accounts receivable are a bit less liquid than Lowe’s. We therefore have a mixed outcome, and cannot say definitively whether Home Depot is more or less liquid. Thus, we have to conclude that Home Depot’s and Lowe’s liquidity are probably very similar.

We have completed our presentation of liquidity decision tools, which can be summa- rized as follows:

or

or

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Preface xxi

“Cautionary Tale” Boxes These give students insights into how the core concepts of finance apply in the real world. Each “Cautionary Tale” box goes behind the headlines of finance pitfalls in the news to show how one of the five principles was forgotten or violated.

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

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.

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 40.)

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40 Part 1 • The Scope and Environment of Financial Management

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 judgments 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 scientific 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 estimate the approximate real interest rate on (1) 3-month Treasury bills, (2) 30-year Treasury bonds, and (3) 30-year Aaa-rated corporate bonds over the 1987–2011 time frame. Furthermore, the annual rate of change in the consumer price index (measured from December to De- cember) is considered a logical measure of past inflation experience. Most of our work is already done for us in Table 2-2. Some of the data from Table 2-2 are displayed here.

SECURITY MEAN NOMINAL

YIELD (%) MEAN INFLATION

RATE (%) INFERRED REAL

RATE (%)

3-month Treasury bills 3.85 2.92 0.93

30-year Treasury bonds 6.14 2.92 3.22

30-year Aaa-rated corporate bonds 7.00 2.92 4.08

DiD you Get it? solvIng FoR The Real RaTe oF InTeResT Nominal or quoted 5 real rate of 1 inflation 1 product of the real rate of rate of interest interest rate 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%

Notice that the mean yield over the 25 years from 1987 to 2011 on all three classes of securities has been used. Likewise, the mean inflation rate over the same time period has been used as an estimate of the inflation premium. The last column provides the approxi- mation for the real interest rate on each class of securities.

Thus, over the 25-year examination period the real rate of interest on 3-month Treasury bills was 0.93 percent versus 3.22 percent on 30-year Treasury bonds, versus 4.08 percent on 30-year Aaa-rated corporate bonds. These three estimates (approximations) of the real interest rate provide a rough guide to the increase in real purchasing power associated with an in-

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“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?” a few pages later in the chapter. This tool provides an essential ingredient to the building-block approach to the material that we use.

Chapter 1 • An Introduction to the Foundations of Financial Management 11

means and that each of us has his or her personal set of values. These values form the basis for what we think is right and wrong. Moreover, every society adopts a set of rules or laws that prescribe what it believes constitutes “doing the 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 ethical 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. Throughout this book, we will point out some of the ethical pitfalls that have tripped up managers.

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?

3 Describe the role of finance in business.

capital budgeting the decision-making process with respect to investment in fixed assets.

capital structure decision the decision- making process with funding choices and the mix of long-term sources of funds.

working capital management the management of the firm’s current assets and short-term financing.

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Concept Check At the end of most major sections, this tool highlights the key ideas just presented and allows students to test their understand- ing of the material.

52 Part 1 • The Scope and Environment of Financial Management

Our goal is not to make you an accountant, but instead to provide you with the tools to understand a firm’s financial situation. With this knowledge, you will be able to under- stand the financial consequences of a company’s decisions and actions—as well as your own.

The financial performance of a firm matters to a lot of groups—the company’s management, its employees, and its investors, just to name a few. If you are an employee, the firm’s performance is important to you because it may determine your annual bonus, your job security, and your opportunity to advance your professional career. This is true whether you are in the firm’s marketing, finance, or human resources department. Moreover, an employee who can see how decisions affect a firm’s finances has a competitive advantage. So regardless of your position in the firm, it is in your own best interest to know the basics of financial statements—even if accounting is not your greatest love.

Let’s begin our review of financial statements by looking at the format and content of the income statement.

The Income Statement An income statement, or profit and loss statement, indicates the amount of profits gen- erated by a firm over a given time period, such as 1 year. In its most basic form, the income statement may be represented as follows:

Sales - expenses = profits

* units sold = total sales). 2. Cost of goods sold, which is the cost of producing or acquiring the goods or services

that were sold. 3. Operating expenses, which include:

a. Marketing and selling expenses (the expenses related to marketing, selling, and distributing the products or services).

b. The firm’s overhead expenses (general and administrative expenses, and deprecia- tion expenses).

1

RemembeR YoUR PRinCiPleS Two principles are especially important in this chapter.

Principle 1 tells us that Cash Flow Is What Matters. At times, cash is more important than profits. Thus, considerable time is devoted to measuring cash flows. Principle 5 warns us that there may be a conflict when managers and owners have dif- ferent incentives. That is, Conflicts of Interest Cause Agency Problems. Because managers’ incentives are at times different from those of owners, the firm’s common stockholders, as well as other providers of capital (such as bankers), need information that can be used to monitor the managers’ actions. Because the owners of large companies do not have access to internal infor- mation about the firm’s operations, they must rely on public information from any and all sources. One of the main sources of such information comes from the company’s financial statements provided by the firm’s accountants. Although this information is by no means perfect, it is an important source used by outsiders to assess a company’s activities. In this chapter, we learn how to use data from the firm’s public financial statements to monitor management’s actions.

rinciple

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Remember Your Principles These in-text inserts appear throughout to allow the student to take time out and reflect on the meaning of the material just presented. The use of these inserts, coupled with the use of the five principles, keeps the student focused on the inter- relationships and motivating factors behind the concepts.

xxii Preface

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

Given this information, what should the nominal rate of interest on Ford bonds maturing in 0–1 year, 1–2 years, 2–3 years, and 3–4 years be? 2-13. (Term structure of interest rates) You want to invest your savings of $20,000 in government securities for the next 2 years. Currently, you can invest either in a security that pays interest of 8 percent per year for the next 2 years or in a security that matures in 1 year but pays only 6 percent interest. If you make the latter choice, you would then reinvest your savings at the end of the first year for another year. a. Why might you choose to make the investment in the 1-year security that pays an interest rate of only 6 percent, as opposed to investing in the 2-year security paying 8 percent? Provide numeri- cal support for your answer. Which theory of term structure have you supported in your answer? b. Assume your required rate of return on the second-year investment is 11 percent; otherwise, you will choose to go with the 2-year security. What rationale could you offer for your preference? 2-14. (Yield curve) If yields on Treasury securities were currently as follows: