Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management, Massachusetts Institute of Technology, Consulting Editor

FINANCIAL MANAGEMENT

Adair Excel Applications for Corporate Finance First Edition

Block, Hirt, and Danielsen Foundations of Financial Management Thirteenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance Tenth Edition

Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition

Brealey, Myers, and Marcus Fundamentals of Corporate Finance Sixth Edition

Brooks FinGame Online 5.0

Bruner Case Studies in Finance: Managing for Corporate Value Creation Sixth Edition

Chew The New Corporate Finance: Where Theory Meets Practice Third Edition

Cornett, Adair, and Nofsinger Finance: Applications and Theory First Edition

DeMello Cases in Finance Second Edition

Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations

Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition

Higgins Analysis for Financial Management

Ninth Edition Kellison

Theory of Interest Third Edition

Kester, Ruback, and Tufano Case Problems in Finance Twelfth Edition

Ross, Westerfield, and Jaffe Corporate Finance Ninth Edition

Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Second Edition

Ross, Westerfield, and Jordan Essentials of Corporate Finance Seventh Edition

Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Ninth Edition

Shefrin Behavioral Corporate Finance: Decisions That Create Value First Edition

White Financial Analysis with an Electronic Calculator Sixth Edition

INVESTMENTS

Bodie, Kane, and Marcus Essentials of Investments Eighth Edition

Bodie, Kane, and Marcus Investments Eighth Edition

Hirschey and Nofsinger Investments: Analysis and Behavior Second Edition

Hirt and Block Fundamentals of Investment Management Ninth Edition

Jordan and Miller Fundamentals of Investments: Valuation and Management Fifth Edition

Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition

Sundaram and Das

Derivatives: Principles and Practice First Edition

FINANCIAL INSTITUTIONS AND MARKETS

Rose and Hudgins Bank Management and Financial Services Eighth Edition

Rose and Marquis Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace Tenth Edition

Saunders and Cornett Financial Institutions Management: A Risk Management Approach Seventh Edition

Saunders and Cornett Financial Markets and Institutions Fourth Edition

INTERNATIONAL FINANCE

Eun and Resnick International Financial Management Fifth Edition

Kuemmerle Case Studies in International Entrepreneurship: Managing and Financing Ventures in the Global Economy First Edition

Robin International Corporate Finance First Edition

REAL ESTATE

Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition

Ling and Archer Real Estate Principles: A Value Approach Third Edition

FINANCIAL PLANNING AND INSURANCE

Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Tenth Edition

Altfest

Personal Financial Planning First Edition

Harrington and Niehaus Risk Management and Insurance Second Edition

Kapoor, Dlabay, and Hughes Focus on Personal Finance: An Active Approach to Help You Develop Successful Financial Skills Third Edition

Kapoor, Dlabay, and Hughes Personal Finance Ninth Edition

Essentials of Corporate Finance

SEVENTH EDITION

Stephen A. Ross Massachusetts Institute of Technology

Randolph W. Westerfield University of Southern California

Bradford D. Jordan University of Kentucky

ESSENTIALS OF CORPORATE FINANCE

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2011, 2008, 2007, 2004, 2001, 1999, 1996 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 0 WCK/WCK 1 0 9 8 7 6 5 4 3 2 1 0

ISBN 978-0-07-338246-3 MHID 0-07-338246-9

Vice president and editor-in-chief: Brent Gordon Publisher: Douglas Reiner Executive editor: Michele Janicek Director of development: Ann Torbert Development editor: Elizabeth Hughes Vice president and director of marketing: Robin J. Zwettler Marketing director: Sankha Basu Senior marketing manager: Melissa Caughlin Vice president of editing, design, and production: Sesha Bolisetty Lead project manager: Christine A. Vaughan Lead production supervisor: Carol A. Bielski Cover and interior designer: Pam Verros Lead media project manager: Brian Nacik

Cover image: © Veer Typeface: 10/12 Times Roman Compositor: MPS Limited, A Macmillan Company Printer: World Color Press Inc.

Library of Congress Cataloging-in-Publication Data

Ross, Stephen A. Essentials of corporate finance / Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan.

-- 7th ed. p. cm. -- (The McGraw-Hill/Irwin series in finance, insurance, and real estate)

Includes index. ISBN-13: 978-0-07-338246-3 (alk. paper) ISBN-10: 0-07-338246-9 (alk. paper) 1. Corporations—Finance. I. Westerfield, Randolph. II. Jordan, Bradford D. III. Title.

HG4026.R676 2011 658.15-dc22

2009049816

www.mhhe.com

About the Authors

Stephen A. Ross

Sloan School of Management, Franco Modigliani Professor of Finance and Economics, Massachusetts Institute of Technology

Stephen A. Ross is the Franco Modigliani Professor of Finance and Economics at the Sloan School of Management, Massachusetts Institute of Technology. One of the most widely published authors in finance and economics, Professor Ross is recognized for his work in developing the Arbitrage Pricing Theory and his substantial contributions to the discipline through his research in signaling, agency theory, option pricing, and the theory of the term structure of interest rates, among other topics. A past president of the American Finance Association, he currently serves as an associate editor of several academic and practitioner journals. He is a trustee of CalTech.

Randolph W. Westerfield

Marshall School of Business, University of Southern California

Randolph W. Westerfield is Dean Emeritus of the University of Southern California’s Marshall School of Business and is the Charles B. Thornton Professor of Finance. He came to USC from the Wharton School, University of Pennsylvania, where he was the chairman of the finance department and a member of the finance faculty for 20 years. He is a member of several public company boards of directors including Health Management Associates, Inc., and the Nicholas Applegate Growth Fund. His areas of expertise include corporate financial policy, investment management, and stock market price behavior.

Bradford D. Jordan

Gatton College of Business and Economics, University of Kentucky

Bradford D. Jordan is Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. He has a long-standing interest in both applied and theoretical issues in corporate finance and has extensive experience teaching all levels of corporate finance and financial management policy. Professor Jordan has published numerous articles on issues such as the cost of capital, capital structure, and the behavior of security prices. He is a past president of the Southern Finance Association, and he is coauthor of Fundamentals of Investments: Valuation and Management, 5th edition, a leading investments text, also published by McGraw-Hill/Irwin.

From the Authors

When we first wrote Essentials of Corporate Finance, we thought there might be a small niche for a briefer book that really focused on what students with widely varying backgrounds and interests needed to carry away from an introductory finance course. We were wrong. There was a huge niche! What we learned is that our text closely matches the needs of instructors and faculty at hundreds of schools across the country. As a result, the growth we have experienced through the first six editions of Essentials has far exceeded anything we thought possible.

With the seventh edition of Essentials of Corporate Finance, we have continued to refine our focus on our target audience, which is the undergraduate student taking a core course in business or corporate finance. This can be a tough course to teach. One reason is that the class is usually required of all business students, so it is not uncommon for a majority of the students to be nonfinance majors. In fact, this may be the only finance course many of them will ever have. With this in mind, our goal in Essentials is to convey the most important concepts and principles at a level that is approachable for the widest possible audience.

To achieve our goal, we have worked to distill the subject down to its bare essentials (hence, the name of this book), while retaining a decidedly modern approach to finance. We have always maintained that the subject of corporate finance can be viewed as the working of a few very powerful intuitions. We also think that understanding the “why” is just as important, if not more so, than understanding the “how,” especially in an introductory course. Based on the gratifying market feedback we have received from our previous editions, as well as from our other text, Fundamentals of Corporate Finance (now in its ninth edition), many of you agree.

By design, this book is not encyclopedic. As the table of contents indicates, we have a total of 18 chapters. Chapter length is about 30 pages, so the text is aimed squarely at a single-term course, and most of the book can be realistically covered in a typical semester or quarter. Writing a book for a one-term course necessarily means some picking and choosing, with regard to both topics and depth of coverage. Throughout, we strike a balance by introducing and covering the essentials (there’s that word again!) while leaving some more specialized topics to follow-up courses.

The other things we have always stressed, and have continued to improve with this edition, are readability and pedagogy. Essentials is written in a relaxed, conversational style that invites the students to join in the learning process rather than being a passive information absorber. We have found that this approach dramatically increases students' willingness to read and learn on their own. Between larger and larger class sizes and the ever-growing demands on faculty time, we think this is an essential (!) feature for a text in an introductory course.

Throughout the development of this book, we have continued to take a hard look at what is truly relevant and useful. In doing so, we have worked to downplay purely theoretical issues and minimize the use of extensive and elaborate calculations to illustrate points that are either intuitively obvious or of limited practical use.

As a result of this process, three basic themes emerge as our central focus in writing Essentials of Corporate Finance:

An Emphasis on Intuition

We always try to separate and explain the principles at work on a commonsense, intuitive level before launching into any specifics. The underlying ideas are discussed first in very general terms and then by way of examples that illustrate in more concrete terms how a financial manager might proceed in a

given situation.

A Unified Valuation Approach

We treat net present value (NPV) as the basic concept underlying corporate finance. Many texts stop well short of consistently integrating this important principle. The most basic and important notion, that NPV represents the excess of market value over cost, often is lost in an overly mechanical approach that emphasizes computation at the expense of comprehension. In contrast, every subject we cover is firmly rooted in valuation, and care is taken throughout to explain how particular decisions have valuation effects.

A Managerial Focus

Students shouldn’t lose sight of the fact that financial management concerns management. We emphasize the role of the financial manager as decision maker, and we stress the need for managerial input and judgment. We consciously avoid “black box” approaches to finance, and, where appropriate, the approximate, pragmatic nature of financial analysis is made explicit, possible pitfalls are described, and limitations are discussed.

Today, as we prepare to once again enter the market, our goal is to stick with and build on the principles that have brought us this far. However, based on an enormous amount of feedback we have received from you and your colleagues, we have made this edition and its package even more flexible than previous editions. We offer flexibility in coverage and pedagogy by providing a wide variety of features in the book to help students to learn about corporate finance. We also provide flexibility in package options by offering the most extensive collection of teaching, learning, and technology aids of any corporate finance text. Whether you use just the textbook, or the book in conjunction with other products, we believe you will find a combination with this edition that will meet your current as well as your changing needs.

Stephen A. Ross Randolph W. Westerfield Bradford D. Jordan

Organization of the Text

We designed Essentials of Corporate Finance to be as flexible and modular as possible. There are a total of nine parts, and, in broad terms, the instructor is free to decide the particular sequence. Further, within each part, the first chapter generally contains an overview and survey. Thus, when time is limited, subsequent chapters can be omitted. Finally, the sections placed early in each chapter are generally the most important, and later sections frequently can be omitted without loss of continuity. For these reasons, the instructor has great control over the topics covered, the sequence in which they are covered, and the depth of coverage.

Just to get an idea of the breadth of coverage in the seventh edition of Essentials, the following grid presents for each chapter some of the most significant new features, as well as a few selected chapter highlights. Of course, in every chapter, figures, opening vignettes, boxed features, and in-chapter illustrations and examples using real companies have been thoroughly updated as well. In addition, the end-of-chapter material has been completely revised.

Learning Solutions

In addition to illustrating relevant concepts and presenting up-to-date coverage, Essentials of

Corporate Finance strives to present the material in a way that makes it engaging and easy to understand. To meet the varied needs of the intended audience, Essentials of Corporate Finance is rich in valuable learning tools and support.

Each feature can be categorized by the benefit to the student:

Real financial decisions Application tools Study aids

REAL FINANCIAL DECISIONS

We have included two key features that help students connect chapter concepts to how decision makers use this material in the real world.

Chapter-Opening Vignettes Each chapter begins with a contemporary real-world event to introduce students to chapter concepts.

Reality Bytes Boxes Most chapters include at least one Reality Bytes box, which takes a chapter issue and shows how it is

being used right now in everyday financial decision making.

APPLICATION TOOLS

Because there is more than one way to solve problems in corporate finance, we include many sections that encourage students to learn or brush up on different problem-solving methods, such as financial calculator and Excel spreadsheet skills.

Chapter Cases Located at the end of most chapters, these cases focus on hypothetical company situations that embody

corporate finance topics. Each case presents a new scenario, data, and a dilemma. Several questions at the end of each case require students to analyze and focus on all of the material they learned from the chapters in that part. Great for homework or in-class exercises and discussions!

Work the Web These in-chapter boxes show students how to research financial issues using the Web and how to use

the information they find to make business decisions. New to this edition, now all of the Work the Web boxes also include interactive follow-up questions and exercises.

Explanatory Web Links These Web links are provided in the margins of the text. They are specifically selected to accompany

text material and provide students and instructors with a quick way to check for additional information using the Internet.

What’s On the Web? These end-of-chapter activities show students how to use and learn from the vast amount of financial

resources available on the Internet.

Calculator Hints Calculator Hints is a self-contained section occurring in various chapters that first introduces students

to calculator basics and then illustrates how to solve problems with the calculator. Appendix D goes into more detailed instructions by solving problems with two specific calculators.

Spreadsheet Strategies The unique Spreadsheet Strategies feature is also in a self-contained section, showing students how to

set up spreadsheets to solve problems—a vital part of every business student’s education.

Spreadsheet Templates Indicated by an Excel icon next to applicable end-of-chapter questions and problems, spreadsheet

templates are available for selected problems on the Student Edition of the book’s Web site, www.mhhe.com/rwj. For even more spreadsheet examples, check out Excel Master, also available on the Web site.

STUDY AIDS

We want students to get the most from this book and this course, and we realize that students have

different learning styles and study needs. We therefore present a number of study features to appeal to a wide range of students.

Learning Objectives Each chapter begins with a number of learning objectives that are key to the student’s understanding of

the chapter. Learning objectives are also linked to end-of-chapter problems and test bank questions.

Pedagogical Use of Color We continue to use a full color palette in Essentials not only to make the text more inviting, but, more

importantly, as a functional element to help students follow the discussion. In almost every chapter, color plays an important, largely self-evident role. A guide to the use of color is found on the back endsheets.

Critical Thinking Questions Every chapter ends with a set of critical thinking questions that challenge the students to apply the

concepts they have learned in the chapter to new situations.

Concept Questions Chapter sections are intentionally kept short to promote a step-by-step, building-block approach to

learning. Each section is then followed by a series of short concept questions that highlight the key ideas just presented. Students use these questions to make sure they can identify and understand the most important concepts as they read.

Numbered Examples Separate numbered and titled examples are extensively integrated into the chapters. These examples

provide detailed applications and illustrations of the text material in a step-by-step format. Each example is completely self-contained so that students don’t have to search for additional information. Based on our classroom testing, these examples are among the most useful learning aids because they provide both detail and explanation.

Summary Tables These tables succinctly restate key principles, results, and equations. They appear whenever it is

useful to emphasize and summarize a group of related concepts.

Key Terms

These are printed in blue the first time they appear, and are defined within the text and in the margin.

Key Equations These are called out in the text and identified by equation numbers. Appendix B shows the key

equations by chapter.

Highlighted Phrases Throughout the text, important ideas are presented separately and printed in a green box to indicate

their importance to the students.

Chapter Summary and Conclusions These paragraphs review the chapter’s key points and provide closure to the chapter.

Chapter Review and Self-Test Problems Review and self-test problems appear after the chapter summaries. Detailed answers to the self-test

problems immediately follow. These questions and answers allow students to test their abilities in solving key problems related to the content of the chapter.

End-of-Chapter Questions and Problems We have found that many students learn better when they have plenty of opportunity to practice. We

therefore provide extensive end-of-chapter questions and problems—now linked to Learning Objectives. The questions and problems are generally separated into three levels—Basic, Intermediate, and Challenge. All problems are fully annotated so that students and instructors can readily identify particular types. Throughout the text, we have worked to supply interesting problems that illustrate real-world applications of chapter material. Answers to selected end-of-chapter problems appear in Appendix C.

Comprehensive Teaching and Learning Package

This edition of Essentials has more options than ever in terms of the textbook, instructor supplements, student supplements, and multimedia products. Mix and match to create a package that is perfect for your course!

INSTRUCTOR SUPPLEMENTS

Assurance of Learning Many educational institutions today are focused on the notion of assurance of learning, an important

element of some accreditation standards. This text is designed specifically to support your assurance of learning initiatives with a simple, yet powerful, solution.

Each test bank question maps to a specific chapter learning outcome/objective listed in the text. You can use the Test Bank software to easily query for learning outcomes/objectives that directly relate to the learning objectives for your course. You can then use the reporting features of the software to aggregate student results in similar fashion, making the collection and presentation of assurance of learning data simple and easy.

Instructor’s CD-ROM ISBN 0077260651 Keep all the supplements in one place! This CD contains all the necessary supplements— Instructor’s

Manual, Solutions, Test Bank, Computerized Test Bank, and PowerPoint—all in one useful product in an electronic format.

Instructor’s Manual (IM) Prepared by Lynn Kugele, The University of Mississippi A great place to find new lecture ideas! This annotated outline for each chapter includes Lecture

Tips, Real-World Tips, Ethics Notes, suggested PowerPoint slides, and, when appropriate, a video synopsis.

Solutions Manual (SM) Prepared by Joseph Smolira, Belmont University The Essentials Solutions Manual provides detailed solutions to the extensive end-of-chapter

material, including concept review questions, quantitative problems, and cases. Select chapters also contain calculator solutions.

Test Bank Prepared by Kay Johnson, Penn State University-Erie Great format for a better testing process! All questions closely link with the text material, listing

section number, Learning Objective, Bloom’s Taxonomy Question Type, and AACSB topic when applicable. Each chapter is divided into five parts. Part I contains questions that test the understanding of the key terms in the book. Part II includes questions patterned after the learning objectives, concept questions, chapter opening vignettes, boxes, and highlighted phrases. Part III contains multiple-choice and true/false problems patterned after the end-of-chapter questions, in basic, intermediate, and challenge levels. Part IV provides essay questions to test problem-solving skills and more advanced understanding of concepts. Part V is a new section that picks up questions directly from the end-of-chapter material and converts them into parallel test bank questions. For

your reference, each test bank question in this part is linked with its corresponding question in the end-of-chapter. Also included are ready-made quizzes to hand out in class.

Computerized Test Bank (Windows) Create your own tests in a snap! These additional questions are found in a computerized test bank

utilizing McGraw-Hill’s EZ Test testing software to quickly create customized exams. This user- friendly program allows instructors to sort questions by format, edit existing questions or add new ones, and scramble questions for multiple versions of the same test.

PowerPoint Presentation System Prepared by Lynn Kugele, The University of Mississippi Customize our content for your course! This presentation has been thoroughly revised to include

more lecture-oriented slides, as well as exhibits and examples both from the book and from outside sources. Applicable slides have Web links that take you directly to specific Internet sites or spreadsheet links to show an example in Excel. You can also go to the Notes Page function for more tips in presenting the slides. New to this edition, additional PPT slides work through example problems for instructors to show in class. If you already have PowerPoint installed on your PC, you have the ability to edit, print, or rearrange the complete presentation to meet your specific needs.

Videos (DVD Format) Current set of videos on hot topics! McGraw-Hill/Irwin has produced a series of finance videos that

are 10-minute case studies on topics such as Financial Markets, Careers, Rightsizing, Capital Budgeting, EVA (Economic Value Added), Mergers and Acquisitions, and International Finance.

ONLINE SUPPORT

Online Learning Center at www.mhhe.com/rwj The Online Learning Center (OLC) contains free access to additional Web-based study and teaching

aids created for this text, such as:

Student Support A great resource for those seeking additional practice, students can access self-grading quizzes,

Excel template problems, and the new tutorial Excel Master designed by Brad Jordan and Joe Smolira.

Premium Content Access iPod Content The library isn’t the place to study! Students lead active and mobile lives.

Harness the power of one of the most popular technology tools today and study on the go. Our innovative approach allows you to download Narrated PowerPoints and quizzes right into your iPod or other MP3 player device.

Narrated PowerPoint Slides Created by Kent Ragan, Missouri State University. The narrated PowerPoints provide real-world examples accompanied by step-by-step instructions and explanations for solving problems presented in the chapter. The Concept Checks from the text are also integrated into the slides to reinforce the key topics in the chapter. Designed specifically to appeal to different learning styles, the slides provide a visual and audio explanation of topics and problems. Click on the slide and listen to the accompanying narration! You can view this slides via computer or download them onto your video iPod.

Teaching Support Along with having access to all of the same material your students can view on the book’s OLC,

you also have password protected access to the Instructor’s Manual, solutions to end-of-chapter

problems and cases, Instructor’s Excel Master, Instructor’s PowerPoint, Excel template solutions, video clips, and video projects and questions.

WebCT and Blackboard course cartridges allow instructors to manage their course and administer examinations online. Increase ease, organization, and efficiency and ask your representative for more details about course cartridges today!

McGraw-Hill Connect Finance

Less Managing. More Teaching. Greater Learning. McGraw-Hill’s Connect Finance is an online assignment and assessment solution that connects

students with the tools and resources they’ll need to achieve success. Connect helps prepare students for their future by enabling faster learning, more efficient studying, and better retention of knowledge.

McGraw-Hill Connect Finance Features Connect Finance offers powerful tools and features to make managing assignments easier, so faculty can spend more time teaching. With Connect Finance, students can engage with their coursework anytime and anywhere, making the learning process more accessible and efficient. Connect Finance offers you the features described below.

Simple Assignment Management With Connect Finance, creating assignments is easier than ever, so you can spend more time teaching and less time managing. The assignment management function enables you to:

Create and deliver assignments easily with selectable end-of-chapter questions and test bank items.

Streamline lesson planning, student progress reporting, and assignment grading to make classroom management more efficient than ever.

Go paperless with the eBook and online submission and grading of student assignments.

Smart Grading When it comes to studying, time is precious. Connect Finance helps students learn more efficiently by providing feedback and practice material when they need it, where they need it. When it comes to teaching, your time is also precious. The grading function enables you to:

Have assignments scored automatically, giving students immediate feedback on their work and side-by-side comparisons with correct answers.

Access and review each response; manually change grades or leave comments for students to review.

Reinforce classroom concepts with practice tests and instant quizzes.

Instructor Library The Connect Finance Instructor Library is your repository for additional resources to improve student engagement in and out of class. You can select and use any asset that enhances your lecture.

Student Study Center The Connect Finance Student Study Center is the place for students to access additional resources. The Student Study Center:

Offers students quick access to lectures, practice materials, eBooks, and more. Provides instant practice material and study questions, easily accessible on the go. Gives students access to the Personal Learning Plan described below.

Connect Study Feature This Study Feature connects each student to the learning resources needed for success in the course. For each chapter, students:

Take a practice test to gauge understanding of the material. Immediately upon completing the practice test, see how their performance compares to the

chapter objectives to be achieved within each section of the chapters. Receive a personal learning plan that recommends specific readings from the text, supplemental

study material, and practice work that will improve their understanding and mastery of each learning objective.

Students Progress Tracking Connect Finance keeps instructors informed about how each student, section, and class is performing, allowing for more productive use of lecture and office hours. The progress-tracking function enables you to:

View scored work immediately and track individual or group performance with assignment and grade reports.

Access an instant view of student or class performance relative to learning objectives.

Lecture Capture through Tegrity Campus For an additional charge, Lecture Capture offers new ways for students to focus on the in-class discussion, knowing they can revisit important topics later. This can be delivered through Connect or separately. See below for more details.

McGraw-Hill Connect Plus Finance McGraw-Hill reinvents the textbook learning experience for the modern student with Connect Plus Finance. A seamless integration of an eBook and Connect Finance, Connect Plus Finance provides all of the Connect Finance features plus the following:

An integrated eBook, allowing for anytime, anywhere access to the textbook. Dynamic links between the problems or questions you assign to your students and the location in

the eBook where that problem or question is covered. A powerful search function to pinpoint and connect key concepts in a snap.

In short, Connect Finance offers you and your students powerful tools and features that optimize your time and energies, enabling you to focus on course content, teaching, and student learning. Connect Finance also offers a wealth of content resources for both instructors and students. This state-of-the-art, thoroughly tested system supports you in preparing students for the world that awaits.

For more information about Connect, go to www.mcgrawhillconnect.com, or contact your McGraw- Hill sales representative.

TEGRITY CAMPUS: LECTURES 24/7

Tegrity Campus is a service that makes class time available 24/7 by automatically capturing every lecture in a searchable format for students to review when they study and complete assignments. With a simple one-click start-and-stop process, you capture all computer screens and corresponding audio. Students can reply any part of any class with easy-to-use browser-based viewing on a PC or Mac.

Educators know that the more students can see, hear, and experience class resources, the better they

learn. In fact, studies prove it. With Tegrity Campus, students quickly recall key moments by using Tegrity Campus’s unique search feature. This search helps students efficiently find what they need, when they need it, across an entire semester of class recordings. Help turn all your students' study time into learning moments immediately supported by your lecture.

To learn more about Tegrity watch a 2-minute Flash demo at http://tegritycampus.mhhe.com.

McGraw–Hill Customer Care Contact Information At McGraw–Hill, we understand that getting the most from new technology can be challenging. That’s

why our services don’t stop after you purchase our products. You can e-mail our Product Specialists 24 hours a day to get product training online. Or you can search our knowledge bank of Frequently Asked Questions on our support Web site. For Customer Support, call 800-331-5094, e-mail hmsupport@mcgraw-hill.com, or visit www.mhhe.com/support. One of our Technical Support Analysts will be able to assist you in a timely fashion.

AVAILABLE FOR PURCHASE & PACKAGING

Student Problem Manual Prepared by Thomas Eyssell, University of Missouri–St. Louis ISBN 0-07-331313-0 Need additional reinforcement of the concepts? This valuable resource provides students with

additional problems for practice. Each chapter begins with Concepts for Review, followed by Chapter Highlights. These re-emphasize the key terms and concepts in the chapter. A short Concept Test, averaging 10 questions and answers, appears next. Each chapter concludes with additional problems for the student to review. Answers to these problems appear at the end of the Student Problem Manual.

Financial Analysis with an Electronic Calculator, Sixth Edition by Mark A. White, University of Virginia, McIntire School of Commerce ISBN-10: 0-07-321709-3; ISBN-13: 978-0-07-321709-3 The information and procedures in this supplementary text enable students to master the use of

financial calculators and develop a working knowledge of financial mathematics and problem solving. Complete instructions are included for solving all major problem types on four popular models: HP 10-B, HP 12-C, TI BA II Plus, and TI-84. Hands-on problems with detailed solutions allow students to practice the skills outlined in the text and obtain instant reinforcement. Financial Analysis with an Electronic Calculator is a self-contained supplement to the introductory financial management course.

Acknowledgments

Clearly, our greatest debt is to our many colleagues (and their students) around the world who, like

us, wanted to try an alternative to what they were using and made the switch to our text. Our plan for developing and improving Essentials, 7e, revolved around the detailed feedback we received from many of our colleagues who had an interest in the book and regularly teach the introductory course. These dedicated scholars and teachers to whom we are very grateful are:

Vaughn S. Armstrong, Utah Valley University Juan Avendano, Augsburg College R. Brian Balyeat, Xavier University John Barkoulas, Georgia Southern University Laura Beal, University of Nebraska at Omaha Stephen G. Buell, Lehigh University Manfen Chen, University of Southern Indiana Ingyu Chiou, Eastern Illinois University Brandon Cline, Clemson University Bruce A. Costa, University of Montana Maria E. de Boyrie, New Mexico State University David Dineen, Seton Hall University Alan Eastman, Indiana University of Pennsylvania David Eckmann, University of Miami Jocelyn Evans, College of Charleston Ramon T. Franklin, Clemson University Sharon H. Garrrison, University of Arizona Victoria Geyfman, Bloomsburg University of Pennsylvania Michael Gunderson, University of Florida John J. Harrington Jr., Seton Hall University John Hatem, Georgia Southern University Rodrigo Hernandez, Radford University Keith Jakob, University of Montana Abu Jalal, Suffolk University Marlin Jensen, Auburn University Samuel Kyle Jones, Stephen F. Austin State University Douglas Jordan, Sonoma State University Ashok K. Kapoor, Augsburg College Howard Keen, Temple University James D. Keys, Florida International University Dr. Ladd Kochman, Kennesaw State University Denise Letterman, Robert Morris University–Pittsburgh, PA Alethea Lindsay, Grambling State University Seongyeon (Sonya) Lim, DePaul University Suzan Murphy, University of Tennessee Milena Petrova, Syracuse University Ted Pilger, Southern Illinois University–Carbondale Alexandros P. Prezas, Suffolk University

Charles Reback, USC Upstate Thomas A. Rhee, California State University–Long Beach Jong C. Rhim, University of Southern Indiana Clarence C. Rose, Radford University Camelia S. Rotaru, St. Edward’s University Andrew Saporoschenko, St. Louis University Michael J. Seiler, Old Dominion University Roger Severns, Minnesota State University–Mankato Gowri Shankar, University of Washington–Bothell Luke Sparvero, SUNY–Oswego Carolyn Spencer, Dowling College Andrew Spieler, Hofstra University Glenn Tanner, Texas State University Hiep Tran, California State University–Sacramento Cathyann Tully, Kean University John B. White, United States Coast Guard Academy Susan White, University of Maryland Fred Yeager, Saint Louis University Tarek Saad Zaher, Indiana State University

We owe a special debt to our colleagues for their dedicated work on the many supplements that accompany this text: Lynn Kugele, University of Mississippi, for her development of the Instructor’s Manual and PowerPoint slides; Kay Johnson, Penn State–Erie, for her extensive revision and improvement of the Test Bank, revision of the Self-Study quizzes and the Test Bank quizzes; Thomas H. Eyssell, University of Missouri–St. Louis, for his revision of the Student Problem Manual; and Kent Ragan, Missouri State University, for his revision of the Narrated PowerPoints.

We also thank Joseph C. Smolira, Belmont University, for his work on this edition. Joe worked closely with us to develop the solutions manual, along with many of the vignettes and real-world examples we have added to this edition.

Laura Coogan, Steve Hailey, and Jacob Prewitt of the University of Kentucky did outstanding work on this edition of Essentials. To them fell the unenviable task of technical proofreading, and, in particular, careful checking of each and every calculation throughout the text.

Finally, in every phase of this project, we have been privileged to have the complete and unwavering support of a great organization, McGraw-Hill/Irwin. We especially thank the McGraw- Hill/Irwin sales organization. The suggestions they provided, their professionalism in assisting potential adopters, and their service to current adopters have been a major factor in our success.

We are deeply grateful to the select group of professionals who served as our development team on this edition: Michele Janicek, Executive Editor; Elizabeth Hughes, Development Editor II; Christine Vaughan, Lead Project Manager; Brian Nacik, Media Project Manager; Pam Verros, Designer; and Carol Bielski, Lead Production Supervisor. Others at McGraw-Hill/Irwin, too numerous to list here, have improved the book in countless ways.

Throughout the development of this edition, we have taken great care to discover and eliminate errors. Our goal is to provide the best textbook available on the subject. To ensure that future editions are error-free, we will gladly offer $10 per arithmetic error to the first individual reporting it as a modest token of our appreciation. More than this, we would like to hear from instructors and students alike. Please send us your comments by using the feedback form on the Essentials of Corporate Finance Online Learning Center at www.mhhe.com/rwj.

Stephen A. Ross Randolph W. Westerfield Bradford D. Jordan

Brief Contents

PART ONE OVERVIEW OF FINANCIAL MANAGEMENT

1 Introduction to Financial Management

PART TWO UNDERSTANDING FINANCIAL STATEMENTS AND CASH FLOW

2 Financial Statements, Taxes, and Cash Flow

3 Working with Financial Statements

PART THREE VALUATION OF FUTURE CASH FLOWS

4 Introduction to Valuation: The Time Value of Money

5 Discounted Cash Flow Valuation

PART FOUR VALUING STOCKS AND BONDS

6 Interest Rates and Bond Valuation

7 Equity Markets and Stock Valuation

PART FIVE CAPITAL BUDGETING

8 Net Present Value and Other Investment Criteria

9 Making Capital Investment Decisions

PART SIX RISK AND RETURN

10 Some Lessons from Capital Market History

11 Risk and Return

PART SEVEN LONG-TERM FINANCING

12 Cost of Capital

13 Leverage and Capital Structure

14 Dividends and Dividend Policy

15 Raising Capital

PART EIGHT SHORT-TERM FINANCIAL MANAGEMENT

16 Short-Term Financial Planning

17 Working Capital Management

PART NINE TOPICS IN BUSINESS FINANCE

18 International Aspects of Financial Management

APPENDICES

A Mathematical Tables

B Key Equations

C Answers to Selected End-of-Chapter Problems

D Using the HP-10B and TI BA II Plus Financial Calculators

Glossary

Name Index

Subject Index

Contents

PART ONE OVERVIEW OF FINANCIAL MANAGEMENT

CHAPTER 1 Introduction to Financial Management

1.1 Finance: A Quick Look The Four Basic Areas Corporate Finance Investments Financial Institutions International Finance Why Study Finance? Marketing and Finance Accounting and Finance Management and Finance You and Finance

1.2 Business Finance and the Financial Manager What Is Business Finance? The Financial Manager Financial Management Decisions Capital Budgeting Capital Structure Working Capital Management Conclusion

1.3 Forms of Business Organization Sole Proprietorship Partnership Corporation A Corporation by Another Name…

1.4 The Goal of Financial Management Profit Maximization The Goal of Financial Management in a Corporation A More General Financial Management Goal Sarbanes-Oxley Act

1.5 The Agency Problem and Control of the Corporation Agency Relationships Management Goals

Do Managers Act in the Stockholders' Interests? Managerial Compensation Control of the Firm Conclusion Stakeholders

1.6 Financial Markets and the Corporation Cash Flows to and from the Firm Primary versus Secondary Markets Primary Markets Secondary Markets

Summary and Conclusions

Critical Thinking and Concepts Review

What’s on the Web?

Chapter Case: The McGee Cake Company

PART TWO UNDERSTANDING FINANCIAL STATEMENTS AND CASH FLOW

CHAPTER 2 Financial Statements, Taxes, and Cash Flow

2.1 The Balance Sheet Assets: The Left-Hand Side Liabilities and Owners Equity: The Right-Hand Side Net Working Capital Liquidity Debt versus Equity Market Value versus Book Value

2.2 The Income Statement GAAP and the Income Statement Noncash Items Time and Costs Earnings Management

2.3 Taxes Corporate Tax Rates Average versus Marginal Tax Rates

2.4 Cash Flow Cash Flow from Assets Operating Cash Flow Capital Spending

Change in Net Working Capital Conclusion A Note on “Free” Cash Flow Cash Flow to Creditors and Stockholders Cash Flow to Creditors Cash Flow to Stockholders Conclusion An Example: Cash Flows for Dole Cola Operating Cash Flow Net Capital Spending Change in NWC and Cash Flow from Assets Cash Flow to Creditors and Stockholders

Summary and Conclusions

Chapter Review and Self-Test Problem

Answer to Chapter Review and Self-Test Problem

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: Cash Flows and Financial Statements at Sunset Boards, Inc.

CHAPTER 3 Working with Financial Statements

3.1 Standardized Financial Statements Common-Size Balance Sheets Common-Size Income Statements

3.2 Ratio Analysis Short-Term Solvency, or Liquidity, Measures Current Ratio Quick (or Acid-Test) Ratio Cash Ratio Long-Term Solvency Measures Total Debt Ratio Times Interest Earned Cash Coverage Asset Management, or Turnover, Measures Inventory Turnover and Days’ Sales in Inventory Receivables Turnover and Days’ Sales in Receivables Total Asset Turnover Profitability Measures

Profit Margin Return on Assets Return on Equity Market Value Measures Price-Earnings Ratio Price-Sales Ratio Market-to-Book Ratio

3.3 The Du Pont Identity An Expanded Du Pont Analysis

3.4 Internal and Sustainable Growth Dividend Payout and Earnings Retention ROA, ROE, and Growth The Internal Growth Rate The Sustainable Growth Rate Determinants of Growth A Note on Sustainable Growth Rate Calculations

3.5 Using Financial Statement Information Why Evaluate Financial Statements? Internal Uses External Uses Choosing a Benchmark Time-Trend Analysis Peer Group Analysis Problems with Financial Statement Analysis

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: Ratios and Financial Planning at S&S Air, Inc.

PART THREE VALUATION OF FUTURE CASH FLOWS

CHAPTER 4 Introduction to Valuation: The Time Value of Money

4.1 Future Value and Compounding

4.1 Future Value and Compounding Investing for a Single Period Investing for More Than One Period

4.2 Present Value and Discounting The Single-Period Case Present Values for Multiple Periods

4.3 More on Present and Future Values Present versus Future Value Determining the Discount Rate Finding the Number of Periods

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

CHAPTER 5 Discounted Cash Flow Valuation

5.1 Future and Present Values of Multiple Cash Flows Future Value with Multiple Cash Flows Present Value with Multiple Cash Flows A Note on Cash Flow Timing

5.2 Valuing Level Cash Flows: Annuities and Perpetuities Present Value for Annuity Cash Flows Annuity Tables Finding the Payment Finding the Rate Future Value for Annuities A Note on Annuities Due Perpetuities

5.3 Comparing Rates: The Effect of Compounding Periods Effective Annual Rates and Compounding Calculating and Comparing Effective Annual Rates EARs and APRs EARs, APRs, Financial Calculators, and Spreadsheets

5.4 Loan Types and Loan Amortization

Pure Discount Loans Interest-Only Loans Amortized Loans

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: S&S Air’s Mortgage

PART FOUR VALUING STOCKS AND BONDS

CHAPTER 6 Interest Rates and Bond Valuation

6.1 Bonds and Bond Valuation Bond Features and Prices Bond Values and Yields Interest Rate Risk Finding the Yield to Maturity: More Trial and Error

6.2 More on Bond Features Is It Debt or Equity? Long-Term Debt: The Basics The Indenture Terms of a Bond Security Seniority Repayment The Call Provision Protective Covenants

6.3 Bond Ratings

6.4 Some Different Types of Bonds Government Bonds Zero Coupon Bonds Floating-Rate Bonds Other Types of Bonds

6.5 Bond Markets How Bonds Are Bought and Sold Bond Price Reporting A Note on Bond Price Quotes

6.6 Inflation and Interest Rates Real versus Nominal Rates The Fisher Effect

6.7 Determinants of Bond Yields The Term Structure of Interest Rates Bond Yields and the Yield Curve: Putting It All Together Conclusion

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: Financing S&S Air’s Expansion Plans with a Bond Issue

CHAPTER 7 Equity Markets and Stock Valuation

7.1 Common Stock Valuation Cash Flows Some Special Cases Zero Growth Constant Growth Nonconstant Growth Components of the Required Return

7.2 Some Features of Common and Preferred Stock Common Stock Features Proxy Voting Classes of Stock Other Rights Dividends Preferred Stock Features Stated Value Cumulative and Noncumulative Dividends

Is Preferred Stock Really Debt?

7.3 The Stock Markets Dealers and Brokers Organization of the NYSE Members Operations Floor Activity NASDAQ Operations ECNs Stock Market Reporting

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: Stock Valuation at Ragan, Inc.

PART FIVE CAPITAL BUDGETING

CHAPTER 8 Net Present Value and Other Investment Criteria

8.1 Net Present Value The Basic Idea Estimating Net Present Value

8.2 The Payback Rule Defining the Rule Analyzing the Rule Redeeming Qualities of the Rule Summary of the Rule

8.3 The Average Accounting Return

8.4 The Internal Rate of Return Problems with the IRR Nonconventional Cash Flows Mutually Exclusive Investments

Redeeming Qualities of the IRR The Modified Internal Rate of Return (MIRR) Method 1: The Discounting Approach Method 2: The Reinvestment Approach Method 3: The Combination Approach MIRR or IRR: Which Is Better?

8.5 The Profitability Index

8.6 The Practice of Capital Budgeting

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: Bullock Gold Mining

CHAPTER 9 Making Capital Investment Decisions

9.1 Project Cash Flows: A First Look Relevant Cash Flows The Stand-Alone Principle

9.2 Incremental Cash Flows Sunk Costs Opportunity Costs Side Effects Net Working Capital Financing Costs Other Issues

9.3 Pro Forma Financial Statements and Project Cash Flows Getting Started: Pro Forma Financial Statements Project Cash Flows Project Operating Cash Flow Project Net Working Capital and Capital Spending Projected Total Cash Flow and Value The Tax Shield Approach

9.4 More on Project Cash Flow

A Closer Look at Net Working Capital Depreciation Modifi ed ACRS (MACRS) Depreciation Book Value versus Market Value An Example: The Majestic Mulch and Compost Company (MMCC) Operating Cash Flows Changes in NWC Capital Spending Total Cash Flow and Value Conclusion

9.5 Evaluating NPV Estimates The Basic Problem Forecasting Risk Sources of Value

9.6 Scenario and Other What-lf Analyses Getting Started Scenario Analysis Sensitivity Analysis

9.7 Additional Considerations in Capital Budgeting Managerial Options and Capital Budgeting Contingency Planning Strategic Options Conclusion Capital Rationing Soft Rationing Hard Rationing

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

Chapter Case: Conch Republic Electronics

PART SIX RISK AND RETURN

CHAPTER 10 Some Lessons from Capital Market History

10.1 Returns

10.1 Returns Dollar Returns Percentage Returns

10.2 The Historical Record A First Look A Closer Look

10.3 Average Returns: The First Lesson Calculating Average Returns Average Returns: The Historical Record Risk Premiums The First Lesson

10.4 The Variability of Returns: The Second Lesson Frequency Distributions and Variability The Historical Variance and Standard Deviation The Historical Record Normal Distribution The Second Lesson Using Capital Market History More on the Stock Market Risk Premium

10.5 More on Average Returns Arithmetic versus Geometric Averages Calculating Geometric Average Returns Arithmetic Average Return or Geometric Average Return?

10.6 Capital Market Efficiency Price Behavior in an Effi cient Market The Effi cient Markets Hypothesis Some Common Misconceptions about the EMH The Forms of Market Effi ciency

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: A Job at S&S Air

CHAPTER 11 Risk and Return

11.1 Expected Returns and Variances Expected Return Calculating the Variance

11.2 Portfolios Portfolio Weights Portfolio Expected Returns Portfolio Variance

11.3 Announcements, Surprises, and Expected Returns Expected and Unexpected Returns Announcements and News

11.4 Risk: Systematic and Unsystematic Systematic and Unsystematic Risk Systematic and Unsystematic Components of Return

11.5 Diversification and Portfolio Risk The Effect of Diversification: Another Lesson from Market History The Principle of Diversification Diversification and Unsystematic Risk Diversification and Systematic Risk

11.6 Systematic Risk and Beta The Systematic Risk Principle Measuring Systematic Risk Portfolio Betas

11.7 The Security Market Line Beta and the Risk Premium The Reward-to-Risk Ratio The Basic Argument The Fundamental Result The Security Market Line Market Portfolios The Capital Asset Pricing Model

11.8 The SML and the Cost of Capital: A Preview The Basic Idea The Cost of Capital

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: The Beta for FLIR Systems

PART SEVEN LONG-TERM FINANCING

CHAPTER 12 Cost of Capital

12.1 The Cost of Capital: Some Preliminaries Required Return versus Cost of Capital Financial Policy and Cost of Capital

12.2 The Cost of Equity The Dividend Growth Model Approach Implementing the Approach Estimating g The SML Approach Implementing the Approach Advantages and Disadvantages of the Approach

12.3 The Costs of Debt and Preferred Stock The Cost of Debt The Cost of Preferred Stock

12.4 The Weighted Average Cost of Capital The Capital Structure Weights Taxes and the Weighted Average Cost of Capital Solving the Warehouse Problem and Similar Capital Budgeting Problems Calculating the WACC for Eastman Chemical Eastman’s Cost of Equity Eastman’s Cost of Debt Eastman’s WACC

12.5 Divisional and Project Costs of Capital The SML and the WACC Divisional Cost of Capital The Pure Play Approach The Subjective Approach

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: Cost of Capital for Hubbard Computer, Inc.

CHAPTER 13 Leverage and Capital Structure

13.1 The Capital Structure Question

13.2 The Effect of Financial Leverage The Impact of Financial Leverage Financial Leverage, EPS, and ROE: An Example EPS versus EBIT Corporate Borrowing and Homemade Leverage

13.3 Capital Structure and the Cost of Equity Capital M&M Proposition I: The Pie Model The Cost of Equity and Financial Leverage: M&M Proposition II Business and Financial Risk

13.4 Corporate Taxes and Capital Structure The Interest Tax Shield Taxes and M&M Proposition I Conclusion

13.5 Bankruptcy Costs Direct Bankruptcy Costs Indirect Bankruptcy Costs

13.6 Optimal Capital Structure The Static Theory of Capital Structure Optimal Capital Structure and the Cost of Capital Capital Structure: Some Managerial Recommendations Taxes Financial Distress

13.7 Observed Capital Structures

13.8 A Quick Look at the Bankruptcy Process Liquidation and Reorganization Bankruptcy Liquidation

Bankruptcy Reorganization Financial Management and the Bankruptcy Process Agreements to Avoid Bankruptcy

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: Stephenson Real Estate Recapitalization

CHAPTER 14 Dividends and Dividend Policy

14.1 Cash Dividends and Dividend Payment Cash Dividends Standard Method of Cash Dividend Payment Dividend Payment: A Chronology More on the Ex-Dividend Date

14.2 Does Dividend Policy Matter? An Illustration of the Irrelevance of Dividend Policy Current Policy: Dividends Set Equal to Cash Flow Alternative Policy: Initial Dividend Greater Than Cash Flow A Test Some Real-World Factors Favoring a Low Payout Taxes Flotation Costs Dividend Restrictions Some Real-World Factors Favoring a High Payout Desire for Current Income Tax and Legal Benefi ts from High Dividends Clientele Effects: A Resolution of Real-World Factors?

14.3 Stock Repurchase: An Alternative to Cash Dividends Cash Dividends versus Repurchase Real-World Considerations in a Repurchase Share Repurchase and EPS

14.4 What We Know and Do Not Know about Dividend and Payout Policies Dividends and Dividend Payers

Corporations Smooth Dividends Putting It All Together Some Survey Evidence on Dividends

14.5 Stock Dividends and Stock Splits Value of Stock Splits and Stock Dividends The Benchmark Case Popular Trading Range Reverse Splits

Summary and Conclusions

Chapter Review and Self-Test Problem

Answer to Chapter Review and Self-Test Problem

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: Electronic Timing, Inc.

CHAPTER 15 Raising Capital

15.1 The Financing Life Cycle of a Firm: Early-Stage Financing and Venture Capital Venture Capital Some Venture Capital Realities Choosing a Venture Capitalist Conclusion

15.2 Selling Securities to the Public: The Basic Procedure

15.3 Alternative Issue Methods

15.4 Underwriters Choosing an Underwriter Types of Underwriting Firm Commitment Underwriting Best Efforts Underwriting Dutch Auction Underwriting The Green Shoe Provision The Aftermarket Lockup Agreements The Quiet Period

15.5 IPOs and Underpricing

Evidence on Underpricing IPO Underpricing: The 1999–2000 Experience Why Does Underpricing Exist?

15.6 New Equity Sales and the Value of the Firm

15.7 The Cost of Issuing Securities

15.8 Issuing Long-Term Debt

15.9 Shelf Registration

Summary and Conclusions

Chapter Review and Self-Test Problem

Answer to Chapter Review and Self-Test Problem

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: S&S Air Goes Public

PART EIGHT SHORT-TERM FINANCIAL MANAGEMENT

CHAPTER 16 Short-Term Financial Planning

16.1 Tracing Cash and Net Working Capital

16.2 The Operating Cycle and the Cash Cycle Defining the Operating and Cash Cycles The Operating Cycle The Cash Cycle The Operating Cycle and the Firm’s Organizational Chart Calculating the Operating and Cash Cycles The Operating Cycle The Cash Cycle Interpreting the Cash Cycle

16.3 Some Aspects of Short-Term Financial Policy The Size of the Firm’s Investment in Current Assets Alternative Financing Policies for Current Assets Which Financing Policy Is Best?

Current Assets and Liabilities in Practice

16.4 The Cash Budget Sales and Cash Collections Cash Outflows The Cash Balance

16.5 Short-Term Borrowing Unsecured Loans Secured Loans Accounts Receivable Financing Inventory Loans Other Sources

16.6 A Short-Term Financial Plan

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: Piepkorn Manufacturing Working Capital Management, Part 1

CHAPTER 17 Working Capital Management

17.1 Float and Cash Management Reasons for Holding Cash The Speculative and Precautionary Motives The Transaction Motive Benefi ts of Holding Cash Understanding Float Disbursement Float Collection Float and Net Float Float Management Ethical and Legal Questions Electronic Data Interchange and Check 21: The End of Float?

17.2 Cash Management: Collection, Disbursement, and Investment Cash Collection and Concentration Components of Collection Time Cash Collection

Lockboxes Cash Concentration Managing Cash Disbursements Increasing Disbursement Float Controlling Disbursements Investing Idle Cash Temporary Cash Surpluses Characteristics of Short-Term Securities Some Different Types of Money Market Securities

17.3 Credit and Receivables Components of Credit Policy Terms of the Sale The Basic Form The Credit Period Cash Discounts Credit Instruments Optimal Credit Policy The Total Credit Cost Curve Organizing the Credit Function Credit Analysis Credit Information Credit Evaluation and Scoring Collection Policy Monitoring Receivables Collection Effort

17.4 Inventory Management The Financial Manager and Inventory Policy Inventory Types Inventory Costs

17.5 Inventory Management Techniques The ABC Approach The Economic Order Quantity Model Inventory Depletion The Carrying Costs The Shortage Costs The Total Costs Extensions to the EOQ Model Safety Stocks Reorder Points Managing Derived-Demand Inventories Materials Requirements Planning Just-in-Time Inventory

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: Piepkorn Manufacturing Working Capital Management, Part 2

PART NINE TOPICS IN BUSINESS FINANCE

CHAPTER 18 International Aspects of Financial Management

18.1 Terminology

18.2 Foreign Exchange Markets and Exchange Rates Exchange Rates Exchange Rate Quotations Cross-Rates and Triangle Arbitrage Types of Transactions

18.3 Purchasing Power Parity Absolute Purchasing Power Parity Relative Purchasing Power Parity The Basic Idea The Result Currency Appreciation and Depreciation

18.4 Exchange Rates and Interest Rates Covered Interest Arbitrage Interest Rate Parity

18.5 Exchange Rate Risk Short-Run Exposure Long-Run Exposure Translation Exposure Managing Exchange Rate Risk

18.6 Political Risk

Summary and Conclusions

Chapter Review and Self-Test Problems

Answers to Chapter Review and Self-Test Problems

Critical Thinking and Concepts Review

Questions and Problems

What’s on the Web?

Chapter Case: S&S Air Goes International

Appendix A Mathematical Tables

Appendix B Key Equations

Appendix C Answers to Selected End-of-Chapter Problems

Appendix D Using the HP-10B and Tl BA II Plus Financial Calculators

Glossary

Name Index

Subject Index

List of Boxes

REALITY BYTES

CHAPTER 1 Corporate Ethics

CHAPTER 2 Fairly Accurate Financial Accounting?

CHAPTER 3 How Fast Is Too Fast?

What’s in a Ratio?

CHAPTER 4 Collectibles as Investments?

CHAPTER 5 Jackpot! 126

An Unwelcome Christmas Present

CHAPTER 6 Exotic Bonds

CHAPTER 7 The Wild, Wild West of Stock Trading

CHAPTER 9 When Things Go Wrong …

CHAPTER 10 The Super Guide to Investing

Can the Pros Beat the Market?

CHAPTER 11 Beta, Beta, Who’s Got the Beta?

CHAPTER 12 EVA: An Old Idea Moves into the Modern Age

The Cost of Capital, Texas Style

CHAPTER 13 Bankruptcy, “Prepack” Style

CHAPTER 14 Stock Buybacks: No End in Sight

CHAPTER 15 IPO Underpricing around the World

The (Mis)-Pricing of Palm, Inc.

Anatomy of an IPO

CHAPTER 16 Cash Cycle Comparison

CHAPTER 17 Inventory Management: From Cars to RFIDs

CHAPTER 18 McPricing

PART ONE Overview of Financial Management

chapter 1 Introduction to Financial Management

AFTER STUDYING THIS CHAPTER, YOU SHOULD BE ABLE TO:

LO 1 Discuss the basic types of financial management decisions and the role of the financial manager.

LO 2 Identify the goal of financial management.

LO 3 Compare the financial implications of the different forms of business organizations.

LO 4 Describe the conflicts of interest that can arise between managers and owners.

Compensation of corporate executives in the United States continues to be a hot-button issue. It is widely viewed that CEO pay has grown to exorbitant levels (at least in some cases). In response, in April 2007, the U.S. House of Representatives passed the “Say on Pay” bill. The bill requires corporations to allow a nonbinding shareholder vote on executive pay. (Note that because the bill applies to corporations, it does not give voters a “say on pay” for U.S. Representatives.)

Specifically, the measure allows shareholders to approve or disapprove a company’s executive compensation plans. Because the bill is nonbinding, it does not permit shareholders to veto a compensation package and does not place limits on executive pay. Some companies had actually already begun initiatives to allow shareholders a say on pay before Congress got involved. On May 5, 2008, Aflac, the insurance company with the well-known “spokesduck,” held the first shareholder vote on executive pay in the United States.

Of course, governmental involvement in corporate compensation did not end there. In early 2009, in the midst of a severe financial crisis, the Obama administration announced a cap of $500,000 on executive salaries for companies that received bailout funds from the federal government. Additionally, executives were prohibited from receiving bonuses above their base pay.

Understanding how a corporation sets executive pay, and the role of shareholders in that process, takes us into issues involving the corporate form of organization, corporate goals, and corporate control, all of which we cover in this chapter.

Visit us at www.mhhe.com/rwj To begin our study of financial management, we address two central issues. First: What is corporate,

or business, finance, and what is the role of the financial manager? Second: What is the goal of financial management?

1.1 FINANCE: A QUICK LOOK

Before we plunge into our study of “corp. fin.,” we think a quick overview of the finance field might be a good idea. Our goal is to clue you in on some of the most important areas in finance and some of the career opportunities available in each. We also want to illustrate some of the ways finance fits in with other areas such as marketing, management, and accounting.

Check out the companion Web site for this text at www.mhhe.com/rwj.

The Four Basic Areas

Traditionally, financial topics are grouped into four main areas:

1. Corporate finance 2. Investments 3. Financial institutions 4. International finance

We discuss each of these next.

Corporate Finance

The first of these four areas, corporate finance, is the main subject of this book. We begin covering this subject with our next section, so we will wait until then to get into any details. One thing we should note is that the term corporate finance seems to imply that what we cover is only relevant to corporations, but the truth is that almost all of the topics we consider are much broader than that. Maybe business finance would be a little more descriptive, but even this is too narrow because at least half of the subjects we discuss in the pages ahead are really basic financial ideas and principles applicable across all the various areas of finance and beyond.

For job descriptions in finance and other areas, visit www.careers-in-business.com.

Investments

Broadly speaking, the investments area deals with financial assets such as stocks and bonds. Some of the more important questions include:

1. What determines the price of a financial asset, such as a share of stock? 2. What are the potential risks and rewards associated with investing in financial assets? 3. What is the best mixture of the different types of financial assets to hold?

Students who specialize in the investments area have various career opportunities. Being a stockbroker is one of the most common. Stockbrokers often work for large companies such as Merrill Lynch, advising customers on what types of investments to consider and helping them make buy and sell decisions. Financial advisers play a similar role, but are not necessarily brokers.

Portfolio management is a second investments-related career path. Portfolio managers, as the name suggests, manage money for investors. For example, individual investors frequently buy into mutual funds. Such funds are simply a means of pooling money that is then invested by a portfolio manager. Portfolio managers also invest and manage money for pension funds, insurance companies, and many other types of institutions.

Security analysis is a third area. A security analyst researches individual investments, such as stock in a particular company, and makes a determination as to whether the price is right. To do so, an analyst delves deeply into company and industry reports, along with a variety of other information sources.

Frequently, brokers and portfolio managers rely on security analysts for information and recommendations.

These investments-related areas, like many areas in finance, share an interesting feature. If they are done well, they can be very rewarding financially (translation: You can make a lot of money). The bad news, of course, is that they can be very demanding and very competitive, so they are definitely not for everybody.

Financial Institutions

Financial institutions are basically businesses that deal primarily in financial matters. Banks and insurance companies would probably be the most familiar to you. Institutions such as these employ people to perform a wide variety of finance-related tasks. For example, a commercial loan officer at a bank would evaluate whether a particular business has a strong enough financial position to warrant extending a loan. At an insurance company, an analyst would decide whether a particular risk was suitable for insuring and what the premium should be.

International Finance

International finance isn’t so much an area as it is a specialization within one of the main areas we described above. In other words, careers in international finance generally involve international aspects of either corporate finance, investments, or financial institutions. For example, some portfolio managers and security analysts specialize in non-U.S. companies. Similarly, many U.S. businesses have extensive overseas operations and need employees familiar with such international topics as exchange rates and political risk. Banks frequently are asked to make loans across country lines, so international specialists are needed there as well.

Why Study Finance?

Who needs to know finance? In a word, you. In fact, there are many reasons you need a working knowledge of finance even if you are not planning a finance career. We explore some of these next.

Marketing and Finance

If you are interested in marketing, you need to know finance because, for example, marketers constantly work with budgets, and they need to understand how to get the greatest payoff from marketing expenditures and programs. Analyzing costs and benefits of projects of all types is one of the most important aspects of finance, so the tools you learn in finance are vital in marketing research, the design of marketing and distribution channels, and product pricing, just to name a few areas.

Financial analysts rely heavily on marketing analysts, and the two frequently work together to evaluate the profitability of proposed projects and products. As we will see in a later chapter, sales projections are a key input in almost every type of new product analysis, and such projections are often developed jointly between marketing and finance.

Beyond this, the finance industry employs marketers to help sell financial products such as bank accounts, insurance policies, and mutual funds. Financial services marketing is one of the most rapidly growing types of marketing, and successful financial services marketers are very well compensated. To work in this area, you obviously need to understand financial products.

Accounting and Finance

For accountants, finance is required reading. In smaller businesses in particular, accountants are often required to make financial decisions as well as perform traditional accounting duties. Further, as the financial world continues to grow more complex, accountants have to know finance to understand the implications of many of the newer types of financial contracts and the impact they have on financial statements. Beyond this, cost accounting and business finance are particularly closely related, sharing many of the same subjects and concerns.

Financial analysts make extensive use of accounting information; they are some of the most important end users. Understanding finance helps accountants recognize what types of information are particularly valuable and, more generally, how accounting information is actually used (and abused) in practice.

Management and Finance

One of the most important areas in management is strategy. Thinking about business strategy without simultaneously thinking about financial strategy is an excellent recipe for disaster, and, as a result, management strategists must have a very clear understanding of the financial implications of business plans.

In broader terms, management employees of all types are expected to have a strong understanding of how their jobs impact profitability, and they are also expected to be able to work within their areas to improve profitability. This is precisely what studying finance teaches you: What are the characteristics of activities that create value?

You and Finance

Perhaps the most important reason to know finance is that you will have to make financial decisions that will be very important to you personally. Today, for example, when you go to work for almost any type of company, you will be asked to decide how you want to invest your retirement funds. We’ll see in a later chapter that what you choose to do can make an enormous difference in your future financial well- being. On a different note, is it your dream to start your own business? Good luck if you don’t understand basic finance before you start; you’ll end up learning it the hard way. Want to know how big your student loan payments are going to be before you take out that next loan? Maybe not, but we’ll show you how to calculate them anyway.

These are just a few of the ways that finance will affect your personal and business lives. Whether you want to or not, you are going to have to examine and understand financial issues, and you are going to have to make financial decisions. We want you to do so wisely, so keep reading.

CONCEPT QUESTIONS

1.1a What are the major areas in finance? 1.1b Besides wanting to pass this class, why do you need to understand finance?

1.2 BUSINESS FINANCE AND THE FINANCIAL MANAGER

Now we proceed to define business finance and the financial manager’s job.

What Is Business Finance?

Imagine you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another:

1. What long-term investments should you take on? That is, what lines of business will you be in, and what sorts of buildings, machinery, and equipment will you need?

2. Where will you get the long-term financing to pay for your investments? Will you bring in other owners, or will you borrow the money?

3. How will you manage your everyday financial activities, such as collecting from customers and paying suppliers?

These are not the only questions, but they are among the most important. Business finance, broadly speaking, is the study of ways to answer these three questions. We’ll be looking at each of them in the chapters ahead.

The Financial Manager

The financial management function is usually associated with a top officer of the firm, often called the chief financial officer (CFO) or vice president of finance. Figure 1.1 is a simplified organizational chart that highlights the finance activity in a large firm. As shown, the vice president of finance coordinates the activities of the treasurer and the controller. The controller’s office handles cost and financial accounting, tax payments, and management information systems. The treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning, and its capital expenditures. These treasury activities are all related to the three general questions raised above, and the chapters ahead deal primarily with these issues. Our study thus bears mostly on activities usually associated with the treasurer’s office. In a smaller firm, the treasurer and controller might be the same person, and there would be only one office.

For current issues facing CFOs, see www.cfo.com.

FIGURE 1.1 A simplified organizational chart.

The exact titles and organization differ from company to company

Financial Management Decisions

As our discussion above suggests, the financial manager must be concerned with three basic types of questions. We consider these in greater detail next.

Capital Budgeting

capital budgeting The process of planning and managing a firm’s long-term investments.

The first question concerns the firm’s long-term investments. The process of planning and managing a

firm’s long-term investments is called capital budgeting. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. Loosely speaking, this means that the value of the cash flow generated by an asset exceeds the cost of that asset.

Regardless of the specific investment under consideration, financial managers must be concerned with how much cash they expect to receive, when they expect to receive it, and how likely they are to receive it. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. In fact, whenever we evaluate a business decision, the size, timing, and risk of the cash flows will be, by far, the most important things we will consider.

Capital Structure

capital structure The mixture of debt and equity maintained by a firm.

The second question for the financial manager concerns how the firm obtains the financing it needs to

support its long-term investments. A firm’s capital structure (or financial structure) refers to the specific mixture of long-term debt and equity the firm uses to finance its operations. The financial manager has two concerns in this area. First: How much should the firm borrow? Second: What are the least expensive sources of funds for the firm?

In addition to deciding on the financing mix, the financial manager has to decide exactly how and where to raise the money. The expenses associated with raising long-term financing can be considerable, so different possibilities must be carefully evaluated. Also, businesses borrow money from a variety of lenders in a number of different ways. Choosing among lenders and among loan types is another job handled by the financial manager.

Working Capital Management

working capital A firm’s short-term assets and liabilities.

The third question concerns working capital management. The term working capital refers to a firm’s

short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. Managing the firm’s working capital is a day-to-day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities related to the firm’s receipt and disbursement of cash.

Some questions about working capital that must be answered are the following: (1) How much cash and inventory should we keep on hand? (2) Should we sell on credit to our customers? (3) How will we obtain any needed short-term financing? If we borrow in the short term, how and where should we do it? This is just a small sample of the issues that arise in managing a firm’s working capital.

Conclusion

The three areas of corporate financial management we have described—capital budgeting, capital structure, and working capital management—are very broad categories. Each includes a rich variety of topics, and we have indicated only a few of the questions that arise in the different areas. The chapters ahead contain greater detail.

CONCEPT QUESTIONS

1.2a What is the capital budgeting decision? 1.2b What do you call the specific mixture of long-term debt and equity that a firm chooses to use? 1.2c Into what category of financial management does cash management fall?

1.3 FORMS OF BUSINESS ORGANIZATION

Large firms in the United States, such as IBM and Exxon, are almost all organized as corporations. We examine the three different legal forms of business organization—sole proprietorship, partnership, and corporation—to see why this is so.

Sole Proprietorship

Msole proprietorship A business owned by a single individual.

A sole proprietorship is a business owned by one person. This is the simplest type of business to

start and is the least regulated form of organization. For this reason, there are more proprietorships than any other type of business, and many businesses that later become large corporations start out as small proprietorships.

The owner of a sole proprietorship keeps all the profits. That’s the good news. The bad news is that the owner has unlimited liability for business debts. This means that creditors can look to the proprietor’s personal assets for payment. Similarly, there is no distinction between personal and business income, so all business income is taxed as personal income.

For more information on forms of business organization, visit www.nolo.com.

The life of a sole proprietorship is limited to the owner’s life span, and, importantly, the amount of equity that can be raised is limited to the proprietor’s personal wealth. This limitation often means that the business is unable to exploit new opportunities because of insufficient capital. Ownership of a sole proprietorship may be difficult to transfer since this requires the sale of the entire business to a new owner.

Partnership

partnership A business formed by two or more individuals or entities.

A partnership is similar to a proprietorship, except that there are two or more owners (partners). In a

general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. The way partnership gains (and losses) are divided is described in the partnership agreement. This agreement can be an informal oral agreement, such as “let’s start a lawn mowing business,” or a lengthy, formal written document.

In a limited partnership, one or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who do not actively participate in the business. A limited partner’s liability for business debts is limited to the amount that partner contributes to the partnership. This form of organization is common in real estate ventures, for example.

The advantages and disadvantages of a partnership are basically the same as those for a proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to form. General partners have unlimited liability for partnership debts, and the partnership terminates when a general partner wishes to sell out or dies. All income is taxed as personal income to the partners, and the amount of equity that can be raised is limited to the partners' combined wealth. Ownership by a general

partner is not easily transferred because a new partnership must be formed. A limited partner’s interest can be sold without dissolving the partnership, but finding a buyer may be difficult.

For more in-depth legal information concerning partnerships, go to www.business- law.freeadvice.com/partnerships/.

Because a partner in a general partnership can be held responsible for all partnership debts, having a written agreement is very important. Failure to spell out the rights and duties of the partners frequently leads to misunderstandings later on. Also, if you are a limited partner, you must not become deeply involved in business decisions unless you are willing to assume the obligations of a general partner. The reason is that if things go badly, you may be deemed to be a general partner even though you say you are a limited partner.

Based on our discussion, the primary disadvantages of sole proprietorships and partnerships as forms of business organization are (1) unlimited liability for business debts on the part of the owners, (2) limited life of the business, and (3) difficulty of transferring ownership. These three disadvantages add up to a single, central problem: The ability of such businesses to grow can be seriously limited by an inability to raise cash for investment.

Corporation

corporation A business created as a distinct legal entity owned by one or more individuals or entities.

The corporation is the most important form (in terms of size) of business organization in the United

States. A corporation is a legal “person” separate and distinct from its owners, and it has many of the rights, duties, and privileges of an actual person. Corporations can borrow money and own property, can sue and be sued, and can enter into contracts. A corporation can even be a general partner or a limited partner in a partnership, and a corporation can own stock in another corporation.

Not surprisingly, starting a corporation is somewhat more complicated than starting the other forms of business organization. Forming a corporation involves preparing articles of incorporation (or a charter) and a set of bylaws. The articles of incorporation must contain a number of things, including the corporation’s name, its intended life (which can be forever), its business purpose, and the number of shares that can be issued. This information must normally be supplied to the state in which the firm will be incorporated. For most legal purposes, the corporation is a “resident” of that state.

The bylaws are rules describing how the corporation regulates its own existence. For example, the bylaws describe how directors are elected. The bylaws may be amended or extended from time to time by the stockholders.

In a large corporation, the stockholders and the managers are usually separate groups. The stockholders elect the board of directors, who then select the managers. Management is charged with running the corporation’s affairs in the stockholders' interests. In principle, stockholders control the corporation because they elect the directors.

As a result of the separation of ownership and management, the corporate form has several advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of the corporation is therefore not limited. The corporation borrows money in its own name. As a result, the stockholders in a corporation have limited liability for corporate debts. The most they can lose is what they have invested.

The relative ease of transferring ownership, the limited liability for business debts, and the unlimited

life of the business are the reasons why the corporate form is superior when it comes to raising cash. If a corporation needs new equity, it can sell new shares of stock and attract new investors. The number of owners can be huge; larger corporations have many thousands or even millions of stockholders. For example, the General Electric Company (better known as GE) has about 10 billion shares outstanding and 4 million shareholders.

The corporate form has a significant disadvantage. Since a corporation is a legal person, it must pay taxes. Moreover, money paid out to stockholders in the form of dividends is taxed again as income to those stockholders. This is double taxation, meaning that corporate profits are taxed twice: at the corporate level when they are earned and again at the personal level when they are paid out.

Today all 50 states have enacted laws allowing for the creation of a relatively new form of business organization, the limited liability company (LLC). The goal of this entity is to operate and be taxed like a partnership but retain limited liability for owners, so an LLC is essentially a hybrid of a partnership and a corporation. Although states have differing definitions for LLCs, the more important scorekeeper is the Internal Revenue Service (IRS). The IRS will consider an LLC a corporation, thereby subjecting it to double taxation, unless it meets certain specific criteria. In essence, an LLC cannot be too corporationlike, or it will be treated as one by the IRS. LLCs have become common. For example, Goldman Sachs, one of Wall Street’s last remaining partnerships, decided to convert from a private partnership to an LLC (it later “went public,” becoming a publicly held corporation). Large accounting firms and law firms by the score have converted to LLCs.

How hard is it to form an LLC? Visit www.llc.com to find out.

A Corporation by Another Name…

The corporate form has many variations around the world. Exact laws and regulations differ, of course, but the essential features of public ownership and limited liability remain. These firms are often called joint stock companies, public limited companies, or limited liability companies.

Table 1.1 gives the names of a few well-known international corporations, their country of origin, and a translation of the abbreviation that follows the company name.

TABLE 1.1 International corporations

You can find the translation for any business type at www.corporateinformation.com.

CONCEPT QUESTIONS

1.3a What are the three forms of business organization? 1.3b What are the primary advantages and disadvantages of sole proprietorships and partnerships? 1.3c What is the difference between a general and a limited partnership? 1.3d Why is the corporate form superior when it comes to raising cash?

1.4 THE GOAL OF FINANCIAL MANAGEMENT

To study financial decision making, we first need to understand the goal of financial management. Such an understanding is important because it leads to an objective basis for making and evaluating financial decisions.

Profit Maximization

Profit maximization would probably be the most commonly cited business goal, but this is not a very precise objective. Do we mean profits this year? If so, then actions such as deferring maintenance, letting inventories run down, and other short-run, cost-cutting measures will tend to increase profits now, but these activities aren’t necessarily desirable.

The goal of maximizing profits may refer to some sort of “long-run” or “average” profits, but it’s unclear exactly what this means. First, do we mean something like accounting net income or earnings per share? As we will see, these numbers may have little to do with what is good or bad for the firm. Second, what do we mean by the long run? As a famous economist once remarked, in the long run, we’re all dead! More to the point, this goal doesn’t tell us the appropriate trade-off between current and future profits.

The Goal of Financial Management in a Corporation

The financial manager in a corporation makes decisions for the stockholders of the firm. Given this, instead of listing possible goals for the financial manager, we really need to answer a more fundamental question: From the stockholders' point of view, what is a good financial management decision?

Find a business finance magazine site that discusses current issues facing the financial executive at www.businessfinancemag.com.

If we assume stockholders buy stock because they seek to gain financially, then the answer is obvious: Good decisions increase the value of the stock, and poor decisions decrease it.

Given our observations, it follows that the financial manager acts in the shareholders' best interests by making decisions that increase the value of the stock. The appropriate goal for the financial manager in a corporation can thus be stated quite easily:

The goal of financial management is to maximize the current value per share of the existing stock.

The goal of maximizing the value of the stock avoids the problems associated with the different goals we discussed above. There is no ambiguity in the criterion, and there is no short-run versus long-run issue. We explicitly mean that our goal is to maximize the current stock value. Of course, maximizing stock value is the same thing as maximizing the market price per share.

REALITY BYTES Corporate Ethics

Large companies are sometimes guilty of unethical behavior. Often this unethical behavior takes the form of false or misleading financial statements. In one of the largest corporate fraud cases in history, energy giant Enron Corporation was forced to file for bankruptcy in December 2001 amid allegations that the company’s financial statements were deliberately misleading and false. Enron’s bankruptcy not only destroyed that company, but its auditor Arthur Andersen as well.

More recently, the 2009 Bank of America acquisition of Merrill Lynch presented a sticky ethical question. Investment banks such as Merrill Lynch are noted for employee bonuses that can run well into the millions of dollars. Generally, these bonuses are paid after the year ends. But with a January 1, 2009, acquisition date looming, bonuses paid to Merrill Lynch employees would be decided by Bank of America management. In an unusual move, John Thain, the CEO of Merrill Lynch, asked the board of directors to decide the bonuses at its November 2008 meeting. Merrill Lynch ended up paying bonuses amounting to $3.6 billion in December 2008, before its acquisition by Bank of America and in a year in which the company lost about $28 billion. The decision resulted in public outcry over the bonuses, as well as an investigation by the New York attorney general’s office to determine whether the timing of the bonuses was securities fraud.

The difference between ethical and unethical behavior can sometimes be murky. For example, many U.S. companies have relocated to Bermuda for reasons beyond the beautiful pink beaches; namely, Bermuda has no corporate income taxes. With a population of less than 65,000, the island is home to more than 13,000 international companies. Stanley Works, the well-known maker of Stanley tools, was among the U.S. corporations that chose to move to the island paradise. By doing so, Stanley estimated that it would save $30 million per year in taxes. Since the goal of the corporation is to maximize shareholder wealth, this would seem like a good move, and the practice is entirely legal. But is it ethical? What are the issues?

Another corporate activity that has generated much controversy is the practice of outsourcing, or offshoring, jobs to other countries. U.S. corporations engage in this practice when labor costs in another country are substantially lower than they are domestically. Again, this is done to maximize shareholder wealth. But, the ethical dilemma in this case is even trickier. Some U.S. workers do lose jobs when offshoring occurs. On the other hand, the Milken Institute estimated that every $1 spent on offshoring a service job to India generated a net value to the United States of $1.13, along with another $.33 to India. And it gets even more complicated: What about foreign companies such as BMW and Toyota who “insource” jobs by building plants in the United States? Is it unethical to outsource U.S. jobs while, at the same time, insourcing jobs from other countries?

A More General Financial Management Goal

Given our goal as stated above (maximize the value of the stock), an obvious question comes up: What is the appropriate goal when the firm has no traded stock? Corporations are certainly not the only type of business, and the stock in many corporations rarely changes hands, so it’s difficult to say what the value per share is at any given time.

As long as we are dealing with for-profit businesses, only a slight modification is needed. The total value of the stock in a corporation is simply equal to the value of the owners' equity. Therefore, a more general way of stating our goal is:

Maximize the market value of the existing owners' equity.

With this goal in mind, it doesn’t matter whether the business is a proprietorship, a partnership, or a corporation. For each of these, good financial decisions increase the market value of the owners' equity and poor financial decisions decrease it.

Finally, our goal does not imply that the financial manager should take illegal or unethical actions in the hope of increasing the value of the equity in the firm. What we mean is that the financial manager best serves the owners of the business by identifying goods and services that add value to the firm because they are desired and valued in the free marketplace. Our nearby Reality Bytes box discusses some recent ethical issues and problems faced by well-known corporations.

Business ethics are considered at www.thecro.com.

Sarbanes-Oxley Act

In response to corporate scandals involving companies such as Enron, WorldCom, Tyco, and Adelphia, Congress enacted the Sarbanes-Oxley Act in 2002. The Act, which is better known as “Sarbox,” is intended to strengthen protection against corporate accounting fraud and financial malpractice. Key elements of Sarbox took effect on November 15, 2004.

Sarbox contains a number of requirements designed to insure that companies tell the truth in their financial statements. For example, the officers of a public corporation must review and sign the annual report. They must attest that the annual report does not contain false statements or material omissions and also that the financial statements fairly represent the company’s financial results. In essence, Sarbox makes management personally responsible for the accuracy of a company’s financial statements.

To find out more about Sarbanes-Oxley, go to www.sarbanes-oxley.com.

Because of its extensive requirements, compliance with Sarbox can be very costly, which has led to some unintended results. Since its implementation, hundreds of public firms have chosen to “go dark,” meaning that their shares would no longer be traded in the major stock markets, in which case Sarbox does not apply. Most of these companies stated that their reason was to avoid the cost of compliance. Ironically, in such cases, the law had the effect of eliminating public disclosure instead of improving it.

Sarbox has also probably affected the number of companies going public in the United States. Recently, many U.S.-based companies have chosen to go public on the London Stock Exchange’s Alternative Investment Market (AIM) instead. The cost savings can be enormous, especially for small companies. For example, Pronotex Technologies, a fuel cell developer based in Southborough, Massachusetts, estimated that it costs about $1 million per year in compliance costs and mailings to stockholders to be listed on the AIM. In contrast, the annual cost to be listed on the NASDAQ would be

about $3 million, with a large part of the increase due to Sarbox compliance costs.

CONCEPT QUESTIONS

1.4a What is the goal of financial management? 1.4b What are some shortcomings of the goal of profit maximization?

1.5 THE AGENCY PROBLEM AND CONTROL OF THE CORPORATION

We’ve seen that the financial manager in a corporation acts in the best interests of the stockholders by taking actions that increase the value of the firm’s stock. However, we’ve also seen that in large corporations ownership can be spread over a huge number of stockholders. This dispersion of ownership arguably means that management effectively controls the firm. In this case, will management necessarily act in the best interests of the stockholders? Put another way, might not management pursue its own goals at the stockholders'expense? We briefly consider some of the arguments below.

Agency Relationships

agency problem The possibility of conflict of interest between the owners and management of a firm.

The relationship between stockholders and management is called an agency relationship. Such a

relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interest. For example, you might hire someone (an agent) to sell a car that you own while you are away at school. In all such relationships, there is a possibility of conflict of interest between the principal and the agent. Such a conflict is called an agency problem.

Suppose you hire someone to sell your car and you agree to pay her a flat fee when she sells the car. The agent’s incentive in this case is to make the sale, not necessarily to get you the best price. If you paid a commission of, say, 10 percent of the sales price instead of a flat fee, then this problem might not exist. This example illustrates that the way an agent is compensated is one factor that affects agency problems.

Management Goals

To see how management and stockholder interests might differ, imagine that a corporation is considering a new investment. The new investment is expected to favorably impact the stock price, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the share value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost.

It is sometimes argued that, left to themselves, managers would tend to maximize the amount of resources over which they have control, or, more generally, business power or wealth. This goal could lead to an overemphasis on business size or growth. For example, cases where management is accused of overpaying to buy another company just to increase the size of the business or to demonstrate corporate power are not uncommon. Obviously, if overpayment does take place, such a purchase does not benefit

the owners of the purchasing company. Our discussion indicates that management may tend to overemphasize organizational survival to

protect job security. Also, management may dislike outside interference, so independence and corporate self-sufficiency may be important goals.

Do Managers Act in the Stockholders' Interests?

Whether managers will, in fact, act in the best interests of stockholders depends on two factors. First, how closely are management goals aligned with stockholder goals? This question relates to the way managers are compensated. Second, can management be replaced if they do not pursue stockholder goals? This issue relates to control of the firm. As we will discuss, there are a number of reasons to think that, even in the largest firms, management has a significant incentive to act in the interests of stockholders.

Managerial Compensation

Management will frequently have a significant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to financial performance in general and oftentimes to share value in particular. For example, managers are frequently given the option to buy stock at a fixed price. The more the stock is worth, the more valuable is this option. The second incentive managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, those managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.

In fact, managers who are successful in pursuing stockholder goals can reap enormous rewards. For example, Larry Ellison, CEO of Oracle, received about $193 million in 2008 alone, which is less than J. K. Rowling ($300 million), but way more than Rachael Ray ($18 million).

Control of the Firm

Control of the firm ultimately rests with stockholders. They elect the board of directors, who, in turn, hires and fires management. The mechanism by which unhappy stockholders can act to replace existing management is called a proxy fight. A proxy is the authority to vote someone else’s stock. A proxy fight develops when a group solicits proxies in order to replace the existing board, and thereby replace existing management.

Another way that management can be replaced is by takeover. Those firms that are poorly managed are more attractive as acquisitions than well-managed firms because a greater profit potential exists. Thus, avoiding a takeover by another firm gives management another incentive to act in the stockholders' interests. Information on executive compensation, along with a ton of other information, can be easily found on the Web for almost any public company. Our nearby Work the Web box shows you how to get started.

WORK THE WEB

The Web is a great place to learn about individual companies, and there are a slew of sites available to help you. Try pointing your Web browser to finance.yahoo.com. Once there, you should see something like this on the page:

To look up a company, you need its “ticker symbol” (or just ticker for short), which is a unique one-

to-four letter identifier. Or, you can just type in a company’s name to find the ticker. For example, we typed in “SIRI,” which is the ticker symbol for Sirius XM Radio, the satellite radio provider. Here is a portion of what we got:

There is a lot of information here and a lot of other links for you to explore, so have at it. By the end

of the term, we hope it all makes sense to you!

Questions

1. Go to finance.yahoo.com and find the current stock prices for Southwest Airlines (LUV), Harley-Davidson (HOG), and Starwood Hotels & Resorts (HOT).

2. Get a quote for American Express (AXP) and follow the “Key Statistics” link. What information is available on this link? What do mrq, ttm, yoy, and Ify mean?

Sometimes it’s hard to tell if a company’s management is really acting in the shareholders' best

interests. For example, in the spring of 2008, Web portal Yahoo! was battling a $42 billion unsolicited takeover bid from software giant Microsoft. Yahoo!’s management argued that the bid significantly undervalued the company, even though it was 62 percent higher than the then-current stock price. In an effort to thwart Microsoft’s takeover attempt, Yahoo! entered into an advertising agreement with Internet search engine rival Google, and it began discussions with other companies such as AOL about a possible merger. In fact, Yahoo! spent $79 million to fight off the Microsoft bid. In the aftermath, Yahoo! founder and CEO Jerry Yang was forced to step down, and Yahoo! stockholders were left saying “boo-hoo.” However, in the spring of 2009, rumors were circulating that Microsoft and Yahoo! were again discussing a deal. If it occurs, it will be interesting to see how much more (or, more likely, less) Microsoft will pay compared to its original offer.

Conclusion

The available theory and evidence are consistent with the view that stockholders control the firm and that stockholder wealth maximization is the relevant goal of the corporation. Even so, there will undoubtedly be times when management goals are pursued at the expense of the stockholders, at least temporarily.

Agency problems are not unique to corporations; they exist whenever there is a separation of ownership and management. This separation is most pronounced in corporations, but it certainly exists in partnerships and proprietorships as well.

Stakeholders

Our discussion thus far implies that management and stockholders are the only parties with an interest in the firm’s decisions. This is an oversimplification, of course. Employees, customers, suppliers, and even the government all have a financial interest in the firm.

stakeholder Someone other than a stockholder or creditor who potentially has a claim on the cash flows of the

firm.

These various groups are called stakeholders in the firm. In general, a stakeholder is someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm. Such groups will also attempt to exert control over the firm, perhaps to the detriment of the owners.

CONCEPT QUESTIONS

1.5a What is an agency relationship? 1.5b What are agency problems and how do they arise? What are agency costs? 1.5c What incentives do managers in large corporations have to maximize share value?

1.6 FINANCIAL MARKETS AND THE CORPORATION

We’ve seen that the primary advantages of the corporate form of organization are that ownership can be transferred more quickly and easily than with other forms and that money can be raised more readily. Both of these advantages are significantly enhanced by the existence of financial markets, and financial markets play an extremely important role in corporate finance.

Cash Flows to and from the Firm

The interplay between the corporation and the financial markets is illustrated in Figure 1.2. The arrows in Figure 1.2 trace the passage of cash from the financial markets to the firm and from the firm back to the financial markets.

FIGURE 1.2 Cash flows between the firm and the financial markets

Suppose we start with the firm selling shares of stock and borrowing money to raise cash. Cash flows to the firm from the financial markets (A). The firm invests the cash in current and fixed (or long- term) assets (B). These assets generate some cash (C), some of which goes to pay corporate taxes (D). After taxes are paid, some of this cash flow is reinvested in the firm (E). The rest goes back to the financial markets as cash paid to creditors and shareholders (F).

A financial market, like any market, is just a way of bringing buyers and sellers together. In financial markets, it is debt and equity securities that are bought and sold. Financial markets differ in detail, however. The most important differences concern the types of securities that are traded, how trading is conducted, and who the buyers and sellers are. Some of these differences are discussed next.

Primary versus Secondary Markets

Financial markets function as both primary and secondary markets for debt and equity securities. The term primary market refers to the original sale of securities by governments and corporations. The secondary markets are those in which these securities are bought and sold after the original sale. Equities are, of course, issued solely by corporations. Debt securities are issued by both governments and corporations. In the discussion that follows, we focus on corporate securities only.

Primary Markets

In a primary-market transaction, the corporation is the seller, and the transaction raises money for the corporation. Corporations engage in two types of primary market transactions: public offerings and private placements. A public offering, as the name suggests, involves selling securities to the general public, whereas a private placement is a negotiated sale involving a specific buyer.

To learn more about the SEC, visit www.sec.gov.

By law, public offerings of debt and equity must be registered with the Securities and Exchange

Commission (SEC). Registration requires the firm to disclose a great deal of information before selling any securities. The accounting, legal, and selling costs of public offerings can be considerable.

Partly to avoid the various regulatory requirements and the expense of public offerings, debt and equity are often sold privately to large financial institutions such as life insurance companies or mutual funds. Such private placements do not have to be registered with the SEC and do not require the involvement of underwriters (investment banks that specialize in selling securities to the public).

To learn more about the exchanges, visit www.nyse.com and www.nasdaq.com.

Secondary Markets

A secondary-market transaction involves one owner or creditor selling to another. It is therefore the secondary markets that provide the means for transferring ownership of corporate securities. Although a corporation is only directly involved in a primary-market transaction (when it sells securities to raise cash), the secondary markets are still critical to large corporations. The reason is that investors are much more willing to purchase securities in a primary-market transaction when they know that those securities can later be resold if desired.

Dealer versus auction markets

There are two kinds of secondary markets: auction markets and dealer markets. Generally speaking, dealers buy and sell for themselves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold. A real estate agent, for example, does not normally buy and sell houses.

Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, a significant fraction of the market for stocks and almost all of the market for long-term debt have no central location; the many dealers are connected electronically.

Auction markets differ from dealer markets in two ways. First, an auction market, or exchange, has a physical location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.

Trading in corporate securities

The equity shares of most of the large firms in the United States trade in organized auction markets. The largest such market is the New York Stock Exchange (NYSE), which accounts for more than 85 percent of all the shares traded in auction markets. Other auction exchanges include the American Stock Exchange (AMEX) and regional exchanges such as the Chicago Stock Exchange.

The Tokyo Stock Exchange in English: www.tse.or.jp/english.

In addition to the stock exchanges, there is a large OTC market for stocks. In 1971, the National

Association of Securities Dealers (NASD) made available to dealers and brokers an electronic quotation system called NASDAQ (NASD Automated Quotations system, pronounced “naz-dak”). There are roughly three times as many companies on NASDAQ as there are on NYSE, but they tend to be much smaller in size and trade less actively. There are exceptions, of course. Both Microsoft and Intel trade OTC, for example. Nonetheless, the total value of NASDAQ stocks is significantly less than the total value of NYSE stocks.

The London Stock Exchange: www.londonstockexchange.com.

There are many large and important financial markets outside the United States, of course, and U.S. corporations are increasingly looking to these markets to raise cash. The Tokyo Stock Exchange and the London Stock Exchange (TSE and LSE, respectively) are two well-known examples. The fact that OTC markets have no physical location means that national borders do not present a great barrier, and there is now a huge international OTC debt market. Because of globalization, financial markets have reached the point where trading in many instruments never stops; it just travels around the world.

Listing

Stocks that trade on an organized exchange (or market) are said to be listed on that exchange. In order to be listed, firms must meet certain minimum criteria concerning, for example, asset size and number of shareholders. These criteria differ for different exchanges.

NYSE has the most stringent requirements of the stock markets in the United States. There are minimums on earnings, assets, and number and market value of shares outstanding.

CONCEPT QUESTIONS

1.6a What is a dealer market? How do dealer and auction markets differ? 1.6b What is the largest auction market in the United States? 1.6c What does OTC stand for? What is the large OTC market for stocks called?

SUMMARY AND CONCLUSIONS

This chapter has introduced you to some of the basic ideas in business finance. In it, we saw that:

1. Business finance has three main areas of concern: 1. Capital budgeting. What long-term investments should the firm take? 2. Capital structure. Where will the firm get the long-term financing to pay for its investments?

In other words, what mixture of debt and equity should we use to fund our operations? 3. Working capital management. How should the firm manage its everyday financial activities?

2. The goal of financial management in a for-profit business is to make decisions that increase the value of the stock, or, more generally, increase the market value of the equity.

3. The corporate form of organization is superior to other forms when it comes to raising money and transferring ownership interests, but it has the significant disadvantage of double taxation.

4. There is the possibility of conflicts between stockholders and management in a large corporation. We called these conflicts agency problems and discussed how they might be controlled

and reduced.

Of the topics we’ve discussed thus far, the most important is the goal of financial management. Throughout the text, we will be analyzing many different financial decisions, but we always ask the same question: How does the decision under consideration affect the value of the equity in the firm?

CRITICAL THINKING AND CONCEPTS REVIEW

LO 1 1.1 The Financial Management Decision Process. What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant. LO 3 1.2 Sole Proprietorships and Partnerships. What are the four primary disadvantages to the sole proprietorship and partnership forms of business organization? What benefits are there to these types of business organization as opposed to the corporate form? LO 3 1.3 Corporations. What is the primary disadvantage of the corporate form of organization? Name at least two of the advantages of corporate organization. LO 3 1.4 Corporate Finance Organization. In a large corporation, what are the two distinct groups that report to the chief financial officer? Which group is the focus of corporate finance? LO 2 1.5 Goal of Financial Management. What goal should always motivate the actions of the firm’s financial manager? LO 4 1.6 Agency Problems. Who owns a corporation? Describe the process whereby the owners control the firm’s management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems can arise? LO 3 1.7 Primary versus Secondary Markets. You’ve probably noticed coverage in the financial press of an initial public offering (IPO) of a company’s securities. Web search company Google is a relatively recent example. Is an IPO a primary-market transaction or a secondary-market transaction? LO 3 1.8 Auction versus Dealer Markets. What does it mean when we say the New York Stock Exchange is an auction market? How are auction markets different from dealer markets? What kind of market is NASDAQ? LO 2 1.9 Not-for-Profit Firm Goals. Suppose you were the financial manager of a not-for- profit business (a not-for-profit hospital, perhaps). What kinds of goals do you think would be appropriate? LO 2 1.10 Ethics and Firm Goals. Can our goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects such as customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored? Try to think of some specific scenarios to illustrate your answer. LO 2 1.11 International Firm Goal. Would our goal of maximizing the value of the stock be different if we were thinking about financial management in a foreign country? Why or why not? LO 4 1.12 Agency Problems. Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock. Your company’s management immediately begins fighting off this hostile bid. Is management acting in the shareholders' best interests? Why or why not? LO 4 1.13 Agency Problems and Corporate Ownership. Corporate ownership varies around

the world. Historically, individuals have owned the majority of shares in public corporations in the United States. In Germany and Japan, however, banks, other large financial institutions, and other companies own most of the stock in public corporations. Do you think agency problems are likely to be more or less severe in Germany and Japan than in the United States? Why? In recent years, large financial institutions such as mutual funds and pension funds have been becoming the dominant owners of stock in the United States, and these institutions are becoming more active in corporate affairs. What are the implications of this trend for agency problems and corporate control? LO 4 1.14 Executive Compensation. Critics have charged that compensation to top management in the United States is simply too high and should be cut back. For example, focusing on large corporations, Larry Ellison, CEO of Oracle, earned about $193 million in 2008 and about $429 million over the 2004–2008 period. Are such amounts excessive? In answering, it might be helpful to recognize that superstar athletes such as Tiger Woods, top entertainers such as Oprah Winfrey, and many others at the top of their respective fields earn at least as much, if not more. LO 4 1.15 Sarbanes-Oxley. In response to the Sarbanes-Oxley Act, many small firms in the United States have opted to “go dark” and delist their stock. Why might a company choose this route? What are the costs of “going dark”?

WHAT’S ON THE WEB?

1.1 Listing Requirements. This chapter discussed some of the listing requirements for the NYSE and NASDAQ. Find the complete listing requirements for the New York Stock Exchange a t www.nyse.com and NASDAQ at www.nasdaq.com. Which has more stringent listing requirements? Why don’t they have the same listing requirements?

1 .2 Business Formation. As you may (or may not) know, many companies incorporate in Delaware for a variety of reasons. Visit Bizfilings at www.bizfilings.com to find out why. Which state has the highest fee for incorporation? For an LLC? While at the site, look at the FAQ section regarding corporations and LLCs.

CHAPTER CASE THE McGEE CAKE COMPANY

In early 2003, Doc and Lyn McGee formed the McGee Cake Company. The company produced a full line of cakes, and its specialties included chess cake*, lemon pound cake, and double-iced, double- chocolate cake. The couple formed the company as an outside interest, and both continued to work at their current jobs. Doc did all the baking, and Lyn handled the marketing and distribution. With good product quality and a sound marketing plan, the company grew rapidly. In early 2008, the company was featured in a widely distributed entrepreneurial magazine. Later that year, the company was featured in Gourmet Desserts, a leading specialty food magazine. After the article appeared in Gourmet Desserts, sales exploded, and the company began receiving orders from all over the world.

*Chess cake is quite delicious and distinct from cheesecake. The origin of the name is obscure.

Because of the increased sales, Doc left his other job, followed shortly by Lyn. The company hired

additional workers to meet demand. Unfortunately, the fast growth experienced by the company led to cash flow and capacity problems. The company is currently producing as many cakes as possible with the assets it owns, but demand for its cakes is still growing. Further, the company has been approached by a national supermarket chain with a proposal to put four of its cakes in all of the chain’s stores, and a national restaurant chain has contacted the company about selling McGee cakes in its restaurants. The restaurant would sell the cakes without a brand name.

Doc and Lyn have operated the company as a sole proprietorship. They have approached you to help manage and direct the company’s growth. Specifically, they have asked you to answer the following questions:

QUESTIONS

1. What are the advantages and disadvantages of changing the company organization from a sole proprietorship to an LLC?

2. What are the advantages and disadvantages of changing the company organization from a sole proprietorship to a corporation?

3. Ultimately, what action would you recommend the company undertake? Why?

PART TWO Understanding Financial Statements and Cash Flow

chapter 2 Financial Statements, Taxes, and Cash Flow

AFTER STUDYING THIS CHAPTER, YOU SHOULD BE ABLE TO:

LO 1 Differentiate between accounting value (or “book” value) and market value.

LO 2 Distinguish accounting income from cash flow.

LO 3 Explain the difference between average and marginal tax rates.

LO 4 Determine a firm’s cash flow from its financial statements.

When a company announces a “write-off,” it frequently means that the value of the company’s assets has declined. For example, in the first quarter of 2009, luxury homebuilder Toll Brothers said it was writing down $157 million in assets, much of which was a reflection of the reduced value of land the company owned. Of course, Toll Brothers was not the only homebuilder suffering. Hovnanian Enterprises announced it would take a $132 million write-off, and Centex Corp. announced a $590 million write-off. At the same time, D. R. Horton, the largest homebuilder by volume, had a much smaller write-off of only $56 million. However, D. R. Horton had already written off $1.15 billion in the fourth quarter of 2008.

So did stockholders in these homebuilders lose hundreds of millions of dollars (or more) because of the write-offs? The answer is probably not. Understanding why ultimately leads us to the main subject of this chapter: that all important substance known as cash flow.

Visit us at www.mhhe.com/rwj In this chapter, we examine financial statements, taxes, and cash flow. Our emphasis is not on

preparing financial statements. Instead, we recognize that financial statements are frequently a key source of information for financial decisions, so our goal is to briefly examine such statements and point out some of their more relevant features. We pay special attention to some of the practical details of cash flow.

As you read, pay particular attention to two important differences: (1) the difference between accounting value and market value and (2) the difference between accounting income and cash flow. These distinctions will be important throughout the book.

2.1 THE BALANCE SHEET

balance sheet Financial statement showing a firm’s accounting value on a particular date.

The balance sheet is a snapshot of the firm. It is a convenient means of organizing and summarizing

what a firm owns (its assets), what a firm owes (its liabilities), and the difference between the two (the firm’s equity) at a given point in time. Figure 2.1 illustrates how the balance sheet is constructed. As shown, the left-hand side lists the assets of the firm, and the right-hand side lists the liabilities and equity.

FIGURE 2.1 The balance sheet.

Left side: Total value of assets. Right side: Total value of liabilities and shareholders'equity.

Assets: The Left-Hand Side

Assets are classified as either current ox fixed. A fixed asset is one that has a relatively long life. Fixed assets can either be tangible, such as a truck or a computer, or intangible, such as a trademark or patent. A current asset has a life of less than one year. This means that the asset will normally convert to cash within 12 months. For example, inventory would normally be purchased and sold within a year and is thus classified as a current asset. Obviously, cash itself is a current asset. Accounts receivable (money owed to the firm by its customers) is also a current asset.

Liabilities and Owners' Equity: The Right-Hand Side

The firm’s liabilities are the first thing listed on the right-hand side of the balance sheet. These are classified as either current or long-term. Current liabilities, like current assets, have a life of less than one year (meaning they must be paid within the year), and they are listed before long-term liabilities. Accounts payable (money the firm owes to its suppliers) is one example of a current liability.

A debt that is not due in the coming year is classified as a long-term liability. A loan that the firm will pay off in five years is one such long-term debt. Firms borrow over the long term from a variety of sources. We will tend to use the terms bonds and bondholders generically to refer to long-term debt and long-term creditors, respectively.

Two excellent sites for company financial information are finance.yahoo.com and money.cnn.com.

Disney has a good investor site at www.disney.com.

Finally, by definition, the difference between the total value of the assets (current and fixed) and the total value of the liabilities (current and long-term) is the shareholders' equity, also called common equity or owners' equity. This feature of the balance sheet is intended to reflect the fact that, if the firm were to sell all of its assets and use the money to pay off its debts, then whatever residual value remained would belong to the shareholders. So, the balance sheet “balances” because the value of the left-hand side

always equals the value of the right-hand side. That is, the value of the firm’s assets is equal to the sum of its liabilities and shareholders' equity:1

1The terms owners' equity, shareholders' equity , and stockholders' equity are used interchangeably to refer to the equity in a corporation. The term net worth is also used. Variations exist in addition to these.

This is the balance sheet identity, or equation, and it always holds because shareholders' equity is defined as the difference between assets and liabilities.

Net Working Capital

networking capital Current assets less current liabilities

As shown in Figure 2.1, the difference between a firm’s current assets and its current liabilities is

called net working capital. Net working capital is positive when current assets exceed current liabilities. Based on the definitions of current assets and current liabilities, this means that the cash that will become available over the next 12 months exceeds the cash that must be paid over that same period. For this reason, net working capital is usually positive in a healthy firm.

Table 2.1 shows a simplified balance sheet for the fictitious U.S. Corporation. There are three particularly important things to keep in mind when examining a balance sheet: liquidity, debt versus equity, and market value versus book value.

TABLE 2.1 Balance sheets for U.S. Corporation

EXAMPLE 2.1

Building the Balance Sheet A firm has current assets of $100, net fixed assets of $500, short-term debt of $70, and long-term debt

of $200. What does the balance sheet look like? What is shareholders' equity? What is net working capital?

In this case, total assets are $100 + 500 = $600 and total liabilities are $70 + 200 = $270, so shareholders' equity is the difference: $600 − 270 = $330. The balance sheet would thus look like:

Net working capital is the difference between current assets and current liabilities, or $100 − 70 = $30.

Liquidity

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