Uneven cash flow stream definition

FREQUENTLY USED SYMBOLS

ACP Average collection period ADR American Depository Receipt APR Annual percentage rate AR Accounts receivable b Beta coefficient, a measure of an asset’s market risk

bL Levered beta bU Unlevered beta

BEP Basic earning power BVPS Book value per share CAPM Capital Asset Pricing Model CCC Cash conversion cycle CF Cash flow; CFt is the cash flow in Period t

CFPS Cash flow per share CR Conversion ratio CV Coefficient of variation Δ Difference, or change (uppercase delta)

Dps Dividend of preferred stock Dt Dividend in Period t

DCF Discounted cash flow D/E Debt-to-equity ratio DPS Dividends per share

DRIP Dividend reinvestment plan DRP Default risk premium DSO Days sales outstanding EAR Effective annual rate, EFF% EBIT Earnings before interest and taxes; net operating income

EBITDA Earnings before interest, taxes, depreciation, and amortization EPS Earnings per share EVA Economic Value Added

F (1) Fixed operating costs (2) Flotation cost

FCF Free cash flow FVN Future value for Year N

FVAN Future value of an annuity for N years g Growth rate in earnings, dividends, and stock prices I Interest rate; also denoted by r

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

IP Inflation premium IPO Initial public offering IRR Internal rate of return LP Liquidity premium M (1) Maturity value of a bond

(2) Margin (profit margin) M/B Market-to-book ratio

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

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

N(di) Represents area under a standard normal distribution function NOPAT Net operating profit after taxes NOWC Net operating working capital

NPV Net present value P (1) Price of a share of stock in Period t; P0 = price of the stock today

(2) Sales price per unit of product sold Pc Conversion price

Pf Price of good in foreign country Ph Price of good in home country PN A stock’s horizon, or terminal, value P/E Price/earnings ratio

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

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

QBE Breakeven quantity r (1) A percentage discount rate, or cost of capital; also denoted by i

(2) Nominal risk-adjusted required rate of return r̄ “r bar,” historic, or realized, rate of return r̂ “r hat,” an expected rate of return r* Real risk-free rate of return rd Before-tax cost of debt re Cost of new common stock (outside equity) rf Interest rate in foreign country rh Interest rate in home country ri Required return for an individual firm or security

rM Return for “the market” or for an “average” stock rNOM Nominal rate of interest; also denoted by iNOM

rps (1) Cost of preferred stock (2) Portfolio’s return

rPER Periodic rate of return rRF Rate of return on a risk-free security rs (1) Required return on common stock

(2) Cost of old common stock (inside equity) ρ Correlation coefficient (lowercase rho); also denoted by R when using historical data

ROA Return on assets ROE Return on equity RP Risk premium

RPM Market risk premium RR Retention rate S (1) Sales

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

SML Security Market Line ∑ Summation sign (uppercase sigma) σ Standard deviation (lowercase sigma) σ2 Variance t Time period T Marginal income tax rate

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

V Variable cost per unit VB Bond value VL Total market value of a levered firm Vop Value of operations Vps Value of preferred stock VU Total market value of an unlevered firm VC Total variable costs w Proportion or weight wd Weight of debt wps Weight of preferred stock ws Weight of common equity raised internally by retaining earnings wce Weight of common equity raised externally by issuing stock

WACC Weighted averaged cost of capital X Exercise price of option

YTC Yield to call YTM Yield to maturity

Financial Management: Theory and Practice THIRTEENTH EDITION

M ICHAE L C . EHRHARDT University of Tennessee

EUGENE F . B R I GHAM University of Florida

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Financial Management: Theory and Practice, Thirteen Edition

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Brief Contents

Preface xix

PART 1 Fundamental Concepts of Corporate Finance 1

CHAPTER 1 An Overview of Financial Management and the Financial Environment 3

Web Extensions 1A: An Overview of Derivatives 1B: A Closer Look at the Stock Markets

CHAPTER 2 Financial Statements, Cash Flow, and Taxes 47

Web Extensions 2A: The Federal Income Tax System for Individuals

CHAPTER 3 Analysis of Financial Statements 87

PART 2 Fixed Income Securities 121

CHAPTER 4 Time Value of Money 123

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

CHAPTER 5 Bonds, Bond Valuation, and Interest Rates 173

Web Extensions 5A: A Closer Look at Zero Coupon Bonds 5B: A Closer Look at TIPS: Treasury Inflation-Protected Securities 5C: A Closer Look at Bond Risk: Duration 5D: The Pure Expectations Theory and Estimation of Forward Rates

PART 3 Stocks and Options 215

CHAPTER 6 Risk, Return, and the Capital Asset Pricing Model 217

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

CHAPTER 7 Stocks, Stock Valuation, and Stock Market Equilibrium 267

Web Extensions 7A: Derivation of Valuation Equations

CHAPTER 8 Financial Options and Applications in Corporate Finance 305

PART 4 Projects and Their Valuation 333

CHAPTER 9 The Cost of Capital 335

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

CHAPTER 10 The Basics of Capital Budgeting: Evaluating Cash Flows 379

Web Extensions 10A: The Accounting Rate of Return (ARR)

CHAPTER 11 Cash Flow Estimation and Risk Analysis 423

Web Extensions 11A: Certainty Equivalents and Risk-Adjusted Discount Rates

i i i

PART 5 Corporate Valuation and Governance 471

CHAPTER 12 Financial Planning and Forecasting Financial Statements 473

Web Extensions 12A: Advanced Techniques for Forecasting Financial Statements Accounts

CHAPTER 13 Corporate Valuation, Value-Based Management and Corporate Governance 511

PART 6 Cash Distributions and Capital Structure 557

CHAPTER 14 Distributions to Shareholders: Dividends and Repurchases 559

CHAPTER 15 Capital Structure Decisions 599

Web Extensions 15A: Degree of Leverage

PART 7 Managing Global Operations 639

CHAPTER 16 Working Capital Management 641

Web Extensions 16A: Secured Short-Term Financing

CHAPTER 17 Multinational Financial Management 691

PART 8 Tactical Financing Decisions 731

CHAPTER 18 Lease Financing 733

Web Extensions 18A: Leasing Feedback 18B: Percentage Cost Analysis 18C: Leveraged Leases

CHAPTER 19 Hybrid Financing: Preferred Stock, Warrants, and Convertibles 759

Web Extensions 19A: Calling Convertible Issues

CHAPTER 20 Initial Public Offerings, Investment Banking, and Financial Restructuring 787

Web Extensions 20A: Rights Offerings

PART 9 Special Topics 825

CHAPTER 21 Mergers, LBOs, Divestitures, and Holding Companies 827

Web Extensions 21A: Projecting Consistent Debt and Interest Expenses

CHAPTER 22 Bankruptcy, Reorganization, and Liquidation 869

Web Extensions 22A: Multiple Discriminant Analysis

CHAPTER 23 Derivatives and Risk Management 899

Web Extensions 23A: Risk Management with Insurance

PART 10 Advanced Issues 929

CHAPTER 24 Portfolio Theory, Asset Pricing Models, and Behavioral Finance 931

CHAPTER 25 Real Options 971

Web Extensions 25A: The Abandonment Real Option 25B: Risk-Neutral Valuation

CHAPTER 26 Analysis of Capital Structure Theory 995

iv Brief Contents

Appendixes

Appendix A Solutions to Self-Test Problems 1029

Appendix B Answers to End-of-Chapter Problems 1063

Appendix C Selected Equations and Data 1071

Appendix D Values of the Areas under the Standard Normal Distribution Function 1085

Glossary 1087 Name Index 1113 Subject Index 1119

Web Chapters CHAPTER 27 Providing and Obtaining Credit

CHAPTER 28 Advanced Issues in Cash Management and Inventory Control

CHAPTER 29 Pension Plan Management

CHAPTER 30 Financial Management in Not-for-Profit Businesses

Brief Contents v

Contents

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xix

PART 1 Fundamental Concepts of Corporate Finance 1

C H A P T E R 1 An Overview of Financial Management and the Financial Environment 3 The Five-Minute MBA 4

Box: Say Hello to the Global Economic Crisis! 5

The Corporate Life Cycle 5 Box: Columbus Was Wrong—the World Is Flat! And Hot, and Crowded! 6

The Primary Objective of the Corporation: Value Maximization 9 Box: Ethics for Individuals and Businesses 10

Box: Corporate Scandals and Maximizing Stock Price 13

An Overview of the Capital Allocation Process 13 Financial Securities 15 The Cost of Money 19 Financial Institutions 23 Financial Markets 27 Trading Procedures in Financial Markets 29 Types of Stock Market Transactions 30

Box: Rational Exuberance? 31

The Secondary Stock Markets 31 Box: Measuring the Market 33

Stock Market Returns 34 The Global Economic Crisis 36 The Big Picture 42 e-Resources 43 Summary 44 Web Extensions

1A: An Overview of Derivatives

1B: A Closer Look at the Stock Markets

C H A P T E R 2 Financial Statements, Cash Flow, and Taxes 47

Box: Intrinsic Value, Free Cash Flow, and Financial Statements 48

Financial Statements and Reports 48 The Balance Sheet 49

Box: Let’s Play Hide-and-Seek! 51

v i

The Income Statement 52 Statement of Stockholders’ Equity 53 Net Cash Flow 54 Statement of Cash Flows 55

Box: Financial Analysis on the WEB 56

Modifying Accounting Data for Managerial Decisions 59 Box: Financial Bamboozling: How to Spot It 63

MVA and EVA 67 Box: Sarbanes-Oxley and Financial Fraud 70

The Federal Income Tax System 71 Summary 76 Web Extensions

2A: The Federal Income Tax System for Individuals

C H A P T E R 3 Analysis of Financial Statements 87

Box: Intrinsic Value and Analysis of Financial Statements 88

Financial Analysis 88 Liquidity Ratios 89 Asset Management Ratios 92

Box: The Price is Right! (Or Wrong!) 93

Debt Management Ratios 95 Profitability Ratios 98

Box: The World Might be Flat, but Global Accounting is Bumpy! The Case of IFRS versus FASB 99

Market Value Ratios 100 Trend Analysis, Common Size Analysis, and Percentage Change Analysis 102 Tying the Ratios Together: The Du Pont Equation 106 Comparative Ratios and Benchmarking 107 Uses and Limitations of Ratio Analysis 108

Box: Ratio Analysis on the Web 109

Looking beyond the Numbers 110 Summary 110

PART 2 Fixed Income Securities 121

C H A P T E R 4 Time Value of Money 123

Box: Corporate Valuation and the Time Value of Money 124

Time Lines 125 Future Values 125

Box: Hints on Using Financial Calculators 129

Box: The Power of Compound Interest 132

Present Values 133

Contents vii

Finding the Interest Rate, I 136 Finding the Number of Years, N 137 Annuities 138 Future Value of an Ordinary Annuity 138 Future Value of an Annuity Due 141 Present Value of Ordinary Annuities and Annuities Due 141

Box: Variable Annuities: Good or Bad? 144

Finding Annuity Payments, Periods, and Interest Rates 144 Perpetuities 146

Box: Using the Internet for Personal Financial Planning 147

Uneven, or Irregular, Cash Flows 148 Future Value of an Uneven Cash Flow Stream 151 Solving for I with Irregular Cash Flows 152 Semiannual and Other Compounding Periods 153

Box: Truth in Lending: What Loans Really Cost 156

Fractional Time Periods 157 Amortized Loans 158 Growing Annuities 159

Box: An Accident Waiting to Happen: Option Reset Adjustable Rate Mortgages 160

Summary 162 Web Extensions

4A: The Tabular Approach

4B: Derivation of Annuity Formulas

4C: Continuous Compounding

C H A P T E R 5 Bonds, Bond Valuation, and Interest Rates 173

Box: Intrinsic Value and the Cost of Debt 174

Who Issues Bonds? 174 Key Characteristics of Bonds 175

Box: Betting With or Against the U.S. Government: The Case of Treasury Bond Credit Default Swaps 176

Bond Valuation 180 Changes in Bond Values over Time 184

Box: Drinking Your Coupons 187

Bonds with Semiannual Coupons 187 Bond Yields 188 The Pre-Tax Cost of Debt: Determinants of Market Interest Rates 191 The Real Risk-Free Rate of Interest, r* 192 The Inflation Premium (IP) 193 The Nominal, or Quoted, Risk-Free Rate of Interest, rRF 195 The Default Risk Premium (DRP) 195

Box: Insuring with Credit Default Swaps: Let the Buyer Beware! 197

viii Contents

Box: Might the U.S. Treasury Bond Be Downgraded? 199

Box: Are Investors Rational? 201

The Liquidity Premium (LP) 201 The Maturity Risk Premium (MRP) 201 The Term Structure of Interest Rates 204 Financing with Junk Bonds 205 Bankruptcy and Reorganization 206 Summary 207 Web Extensions

5A: A Closer Look at Zero Coupon Bonds

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

5C: A Closer Look at Bond Risk: Duration

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

PART 3 Stocks and Options 215

C H A P T E R 6 Risk, Return, and the Capital Asset Pricing Model 217

Box: Intrinsic Value, Risk, and Return 219

Returns on Investments 219 Stand-Alone Risk 220

Box: What Does Risk Really Mean? 227

Box: The Trade-off between Risk and Return 229

Risk in a Portfolio Context 231 Box: How Risky Is a Large Portfolio of Stocks? 236

Box: The Benefits of Diversifying Overseas 239

Calculating Beta Coefficients 243 The Relationship between Risk and Return 246

Box: Another Kind of Risk: The Bernie Madoff Story 252

Some Concerns about Beta and the CAPM 253 Some Concluding Thoughts: Implications for Corporate Managers and Investors 253 Summary 255 Web Extensions

6A: Continuous Probability Distributions

6B: Estimating Beta with a Financial Calculator

C H A P T E R 7 Stocks, Stock Valuation, and Stock Market Equilibrium 267

Box: Corporate Valuation and Stock Prices 268

Legal Rights and Privileges of Common Stockholders 268 Types of Common Stock 269 The Market Stock Price versus Intrinsic Value 270 Stock Market Reporting 272

Contents ix

Valuing Common Stocks 273 Valuing a Constant Growth Stock 276 Expected Rate of Return on a Constant Growth Stock 279 Valuing Nonconstant Growth Stocks 281 Stock Valuation by the Free Cash Flow Approach 285 Market Multiple Analysis 285 Preferred Stock 286 Stock Market Equilibrium 287 The Efficient Markets Hypothesis 290

Box: Rational Behavior versus Animal Spirits, Herding, and Anchoring Bias 293

Summary 294 Web Extensions

7A: Derivation of Valuation Equations

C H A P T E R 8 Financial Options and Applications in Corporate Finance 305

Box: The Intrinsic Value of Stock Options 306

Overview of Financial Options 306 Box: Financial Reporting for Employee Stock Options 309

The Single-Period Binomial Option Pricing Approach 310 The Single-Period Binomial Option Pricing Formula 314 The Multi-Period Binomial Option Pricing Model 316 The Black-Scholes Option Pricing Model (OPM) 319

Box: Taxes and Stock Options 324

The Valuation of Put Options 325 Applications of Option Pricing in Corporate Finance 326 Summary 328

PART 4 Projects and Their Valuation 333

C H A P T E R 9 The Cost of Capital 335

Box: Corporate Valuation and the Cost of Capital 336

The Weighted Average Cost of Capital 337 Basic Definitions 338 Cost of Debt, rd(1 − T) 340 Cost of Preferred Stock, rps 342

Box: GE and Warren Buffett: The Cost of Preferred Stock 343

Cost of Common Stock, rs 344 The CAPM Approach 345 Dividend-Yield-Plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach 353 Over-Own-Bond-Yield-Plus-Judgmental-Risk-Premium Approach 355 Comparison of the CAPM, DCF, and Over-Own-Bond-Yield-Plus-Judgmental-Risk-

Premium Methods 356

x Contents

Adjusting the Cost of Equity for Flotation Costs 357 Composite, or Weighted Average, Cost of Capital, WACC 358

Box: Global Variations in the Cost of Capital 361

Factors That Affect the WACC 361 Adjusting the Cost of Capital for Risk 363 Privately Owned Firms and Small Businesses 366 Four Mistakes to Avoid 367 Summary 368 Web Extensions

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

C H A P T E R 1 0 The Basics of Capital Budgeting: Evaluating Cash Flows 379

Box: Corporate Valuation and Capital Budgeting 381

An Overview of Capital Budgeting 381 Net Present Value (NPV) 383 Internal Rate of Return (IRR) 387

Box: Why NPV Is Better Than IRR 389

Multiple Internal Rates of Return 390 Reinvestment Rate Assumptions 392 Modified Internal Rate of Return (MIRR) 393 NPV Profiles 396 Profitability Index (PI) 400 Payback Period 401 Conclusions on Capital Budgeting Methods 403 Decision Criteria Used in Practice 405 Other Issues in Capital Budgeting 405 Summary 411 Web Extensions

10A: The Accounting Rate of Return (ARR)

C H A P T E R 1 1 Cash Flow Estimation and Risk Analysis 423

Box: Corporate Valuation, Cash Flows, and Risk Analysis 424

Conceptual Issues 424 Analysis of an Expansion Project 429 Risk Analysis in Capital Budgeting 435 Measuring Stand-Alone Risk 436 Sensitivity Analysis 436 Scenario Analysis 439 Monte Carlo Simulation 442

Box: Are Bank Stress Tests Stressful Enough? 445

Project Risk Conclusions 446 Box: Capital Budgeting Practices in the Asian/Pacific Region 447

Contents xi

Replacement Analysis 448 Real Options 449 Phased Decisions and Decision Trees 451 Summary 454 Appendix 11A Tax Depreciation 468 Web Extensions

11A: Certainty Equivalents and Risk-Adjusted Discount Rates

PART 5 Corporate Valuation and Governance 471

C H A P T E R 1 2 Financial Planning and Forecasting Financial Statements 473

Box: Corporate Valuation and Financial Planning 474 Overview of Financial Planning 474 Sales Forecast 476 Additional Funds Needed (AFN) Method 478 Forecasted Financial Statements Method 482 Forecasting When the Ratios Change 496 Summary 499 Web Extensions

12A: Advanced Techniques for Forecasting Financial Statements Accounts

C H A P T E R 1 3 Corporate Valuation, Value-Based Management and Corporate

Governance 511 Box: Corporate Valuation: Putting the Pieces Together 512

Overview of Corporate Valuation 513 The Corporate Valuation Model 514 Value-Based Management 521 Managerial Behavior and Shareholder Wealth 530 Corporate Governance 531

Box: Let’s Go to Miami! IBM’s 2009 Annual Meeting 533

Box: Would the U.S. Government Be an Effective Board Director? 536

Box: Shareholder Reactions to the Crisis 538

Box: The Sarbanes-Oxley Act of 2002 and Corporate Governance 540

Box: International Corporate Governance 542

Employee Stock Ownership Plans (ESOPs) 543 Summary 546

PART 6 Cash Distributions and Capital Structure 557

C H A P T E R 1 4 Distributions to Shareholders: Dividends and Repurchases 559

Box: Uses of Free Cash Flow: Distributions to Shareholders 560

An Overview of Cash Distributions 560

xii Contents

Procedures for Cash Distributions 562 Cash Distributions and Firm Value 564 Clientele Effect 567 Information Content, or Signaling, Hypothesis 568 Implications for Dividend Stability 569

Box: Will Dividends Ever Be the Same? 570

Setting the Target Distribution Level: The Residual Distribution Model 570 The Residual Distribution Model in Practice 572 A Tale of Two Cash Distributions: Dividends versus Stock Repurchases 573 The Pros and Cons of Dividends and Repurchases 582

Box: Dividend Yields around the World 584

Other Factors Influencing Distributions 584 Summarizing the Distribution Policy Decision 585 Stock Splits and Stock Dividends 587

Box: Talk about a Split Personality! 588

Dividend Reinvestment Plans 590 Summary 591

C H A P T E R 1 5 Capital Structure Decisions 599

Box: Corporate Valuation and Capital Structure 600

A Preview of Capital Structure Issues 600 Business Risk and Financial Risk 603 Capital Structure Theory 609

Box: Yogi Berra on the MM Proposition 611

Capital Structure Evidence and Implications 618 Box: Taking a Look at Global Capital Structures 620

Estimating the Optimal Capital Structure 621 Anatomy of a Recapitalization 625

Box: Deleveraging 630

Summary 630 Web Extensions

15A: Degree of Leverage

PART 7 Managing Global Operations 639

C H A P T E R 1 6 Working Capital Management 641

Box: Corporate Valuation and Working Capital Management 642

Current Asset Holdings 643 Current Assets Financing Policies 644 The Cash Conversion Cycle 648

Box: Some Firms Operate with Negative Working Capital! 653

The Cash Budget 654

Contents xiii

Cash Management and the Target Cash Balance 657 Box: The CFO Cash Management Scorecard 658

Cash Management Techniques 659 Inventory Management 661

Box: Supply Chain Management 662

Receivables Management 663 Box: Supply Chain Finance 665

Accruals and Accounts Payable (Trade Credit) 667 Short-Term Marketable Securities 670 Short-Term Financing 672 Short-Term Bank Loans 672 Commercial Paper 676 Use of Security in Short-Term Financing 677 Summary 678 Web Extensions

16A: Secured Short-Term Financing

C H A P T E R 1 7 Multinational Financial Management 691

Box: Corporate Valuation in a Global Context 692

Multinational, or Global, Corporations 692 Multinational versus Domestic Financial Management 693 Exchange Rates 694 Exchange Rates and International Trade 698 The International Monetary System and Exchange Rate Policies 699 Trading in Foreign Exchange 703 Interest Rate Parity 704 Purchasing Power Parity 706

Box: Hungry for a Big Mac? Go To Malaysia! 708

Inflation, Interest Rates, and Exchange Rates 709 International Money and Capital Markets 710

Box: Greasing the Wheels of International Business 711

Box: Stock Market Indices around the World 713

Multinational Capital Budgeting 714 Box: Consumer Finance in China 715

International Capital Structures 718 Multinational Working Capital Management 720 Summary 723

PART 8 Tactical Financing Decisions 731

C H A P T E R 1 8 Lease Financing 733 Types of Leases 734

xiv Contents

Tax Effects 736 Financial Statement Effects 738

Box: Off–Balance Sheet Financing: Is It Going to Disappear? 740

Evaluation by the Lessee 740 Evaluation by the Lessor 745 Other Issues in Lease Analysis 747

Box: What You Don’t Know Can Hurt You! 748

Box: Lease Securitization 750

Other Reasons for Leasing 751 Summary 753 Web Extensions

18A: Leasing Feedback

18B: Percentage Cost Analysis

18C: Leveraged Leases

C H A P T E R 1 9 Hybrid Financing: Preferred Stock, Warrants, and Convertibles 759 Preferred Stock 761

Box: The Romance Had No Chemistry, But It Had a Lot of Preferred Stock! 762

Warrants 765 Convertible Securities 770 A Final Comparison of Warrants and Convertibles 777 Reporting Earnings When Warrants or Convertibles Are Outstanding 778 Summary 779 Web Extensions

19A: Calling Convertible Issues

C H A P T E R 2 0 Initial Public Offerings, Investment Banking, and Financial

Restructuring 787 The Financial Life Cycle of a Start-up Company 788 The Decision to Go Public 789 The Process of Going Public: An Initial Public Offering 791 Equity Carve-outs: A Special Type of IPO 799 Other Ways to Raise Funds in the Capital Markets 800

Box: Bowie Bonds Ch-Ch-Change Asset Securitization 803

Investment Banking Activities and Their Role in the Global Economic Crisis 803 Box: Investment Banks and the Global Economic Crisis 805

The Decision to Go Private 806 Managing the Maturity Structure of Debt 808 Refunding Operations 810

Box: TVA Ratchets Down Its Interest Expenses 813

Managing the Risk Structure of Debt with Project Financing 815 Summary 817 Web Extensions

20A: Rights Offerings

Contents xv

PART 9 Special Topics 825

C H A P T E R 2 1 Mergers, LBOs, Divestitures, and Holding Companies 827 Rationale for Mergers 828 Types of Mergers 830 Level of Merger Activity 831 Hostile versus Friendly Takeovers 832 Merger Regulation 833 Overview of Merger Analysis 834 The Adjusted Present Value (APV) Approach 835 The Free Cash Flow to Equity (FCFE) Approach 838 Illustration of the Three Valuation Approaches for a Constant Capital Structure 840 Setting the Bid Price 845 Analysis When There Is a Permanent Change in Capital Structure 847 Taxes and the Structure of the Takeover Bid 849

Box: Tempest in a Teapot? 850

Financial Reporting for Mergers 852 Analysis for a “True Consolidation” 855 The Role of Investment Bankers 855 Who Wins: The Empirical Evidence 857

Box: Merger Mistakes 858

Corporate Alliances 858 Leveraged Buyouts 859 Divestitures 859 Holding Companies 860 Summary 862 Web Extensions

21A: Projecting Consistent Debt and Interest Expenses

C H A P T E R 2 2 Bankruptcy, Reorganization, and Liquidation 869 Financial Distress and Its Consequences 870 Issues Facing a Firm in Financial Distress 871 Settlements without Going through Formal Bankruptcy 872 Federal Bankruptcy Law 874 Reorganization in Bankruptcy 875 Liquidation in Bankruptcy 885

Box: A Nation of Defaulters? 888

Other Motivations for Bankruptcy 889 Some Criticisms of Bankruptcy Laws 889 Summary 890 Web Extensions

22A: Multiple Discriminant Analysis

xvi Contents

C H A P T E R 2 3 Derivatives and Risk Management 899

Box: Corporate Valuation and Risk Management 900

Reasons to Manage Risk 901 Background on Derivatives 903 Derivatives in the News 904 Other Types of Derivatives 907 Corporate Risk Management 913

Box: Enterprise Risk Management and Value at Risk 916

Using Derivatives to Reduce Risks 917 Box: Risk Management in the Cyber Economy 920

Summary 924 Web Extensions

23A: Risk Management with Insurance

PART 10 Advanced Issues 929

C H A P T E R 2 4 Portfolio Theory, Asset Pricing Models, and Behavioral Finance 931

Box: Corporate Valuation and Risk 932

Efficient Portfolios 932 Choosing the Optimal Portfolio 936 The Basic Assumptions of the Capital Asset Pricing Model 939 The Capital Market Line and the Security Market Line 940 Calculating Beta Coefficients 944

Box: Skill or Luck? 945

Empirical Tests of the CAPM 952 Arbitrage Pricing Theory 954 The Fama-French Three-Factor Model 957 An Alternative Theory of Risk and Return: Behavioral Finance 961 Summary 963

C H A P T E R 2 5 Real Options 971 Valuing Real Options 972 The Investment Timing Option: An Illustration 973 The Growth Option: An Illustration 982 Concluding Thoughts on Real Options 986 Summary 989 Web Extensions

25A: The Abandonment Real Option

25B: Risk-Neutral Valuation

Contents xvii

C H A P T E R 2 6 Analysis of Capital Structure Theory 995

Box: Corporate Valuation and Capital Structure Decisions 996

Capital Structure Theory: Arbitrage Proofs of the Modigliani-Miller Models 996 Introducing Personal Taxes: The Miller Model 1006 Criticisms of the MM and Miller Models 1010 An Extension of the MM Model: Nonzero Growth and a Risky Tax Shield 1011 Risky Debt and Equity as an Option 1015 Capital Structure Theory: Our View 1019 Summary 1021

Appendix A Solutions to Self-Test Problems . . . . . . . . . . . . . . . . . . . . . . . . . . 1029 Appendix B Answers to End-of-Chapter Problems . . . . . . . . . . . . . . . . . . . . . 1063 Appendix C Selected Equations and Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1071 Appendix D Values of the Areas under the Standard Normal

Distribution Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1085 Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1087 Name Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1113 Subject Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1119

WEB CHAPTERS

C H A P T E R 2 7 Providing and Obtaining Credit

C H A P T E R 2 8 Advanced Issues in Cash Management and Inventory Control

C H A P T E R 2 9 Pension Plan Management

C H A P T E R 3 0 Financial Management in Not-for-Profit Businesses

xviii Contents

Preface

When we wrote the first edition of Financial Management: Theory and Practice, we had four goals: (1) to create a text that would help students make better financial decisions; (2) to provide a book that could be used in the introductory MBA course, but one that was complete enough for use as a reference text in follow-on case courses and after graduation; (3) to motivate students by demonstrating that finance is both interesting and relevant; and (4) to make the book clear enough so that students could go through the material without wasting either their time or their professor’s time trying to figure out what we were saying.

The collapse of the sub-prime mortgage market, the financial crisis, and the global economic crisis make it more important than ever for students and managers to understand the role that finance plays in a global economy, in their own companies, and in their own lives. So in addition to the four goals listed above, this edition has a fifth goal, to prepare students for a changed world.

INTRINSIC VALUATION AS A UNIFYING THEME Our emphasis throughout the book is on the actions that a manager can and should take to increase the intrinsic value of the firm. Structuring the book around intrinsic valuation enhances continuity and helps students see how various topics are related to one another.

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

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

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

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

resource Be sure to visit the Financial Management: Theory and Practice (13th Edition) Web site at www.cengage.com/ brigham. This site provides access for instructors and students.

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www.cengage.com/brigham
www.cengage.com/brigham
3. Most students—even those who do not plan to major in finance—are interested in investments. The ability to learn is a function of individual interest and moti- vation, so Financial Management’s early coverage of securities and security markets is pedagogically sound.

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

INTENDED MARKET AND USE Financial Management is designed primarily for use in the introductory MBA finance course and as a reference text in follow-on case courses and after graduation. There is enough material for two terms, especially if the book is supplemented with cases and/or selected readings. The book can also be used as an undergraduate introductory text with exceptionally good students, or where the introductory course is taught over two terms.

IMPROVEMENTS IN THE 13TH EDITION As in every revision, we updated and clarified materials throughout the text, reviewing the entire book for completeness, ease of exposition, and currency. We made hundreds of small changes to keep the text up-to-date, with particular emphasis on updating the real world examples and including the latest changes in the financial environment and financial theory. In addition, we made a number of larger changes. Some affect all chap- ters, some involve reorganizing sections among chapters, and some modify material covered within specific chapters.

CHANGES THAT AFFECT ALL CHAPTERS Reorganization to better accommodate one-semester and two-semester sequences. Finance is taught as a one-semester course at many schools, so we moved the essential material into the first 17 chapters. The remaining chapters cover addi- tional topics and provide more advanced treatment of the essential material in the first 17 chapters. This makes it easy for a professor teaching a one-semester course to cover the essential materials and then pick and choose from the remaining topics if time per- mits. If finance is taught in a two-semester sequence, the first semester can focus on the essential materials in the first 17 chapters and the second semester can focus on advanced materials in the remaining chapters, perhaps supplemented with cases. The global economic crisis. In virtually every chapter we use real world examples to show how the chapter’s topics are related to some aspect of the global economic crisis. In addition, many chapters have new “Global Economic Crisis” boxes that fo- cus on particularly important issues related to the crisis. The big picture. Students often fail to see the forest for the trees, and this is espe- cially true in finance because students must learn new vocabularies and analytical tools. To help students understand the big picture and integrate the different parts into an overall framework, we have added a graphic at the beginning of each chap- ter (and in the PowerPoint shows) that clearly illustrates where the chapter’s topics fit into the big picture. Following is an example from Chapter 9:

xx Preface

Value = + … ++ FCF1 FCF∞

(1 + WACC)1

FCF2

(1 + WACC)2 (1 + WACC)∞

Free cash flow (FCF)

Market interest rates

Firm’s business riskMarket risk aversion

Firm’s debt/equity mixCost of debt Cost of equity

Weighted average cost of capital

(WACC)

Required investments in operating capital

Net operating profit after taxes −

=

Determinants of Intrinsic Value: The Weighted Average Cost of Capital

Additional integration of the textbook and the accompanying Excel Tool Kit spreadsheet models for each chapter. Many figures in the textbook are actually screen shots from the chapter’s Excel Tool Kit model. This makes the analysis more transparent to the students and better enables them to follow the analysis in the Excel model.

Signficant Reorganization of Some Chapters Financial markets and performance measures. Chapter 1 still addresses the financial environment, but now is followed by two chapters focused on measuring the firm’s performance in the financial environment by understanding financial state- ments, calculating free cash flow, and analyzing ratios.

Time value of money and bond valuation. Chapter 4 covers the time value of money and Chapter 5 applies these concepts to bond pricing. Thus, students learn a tool and then immediately use the tool.

Dividends and stock repurchases before capital structure decisions. We now cover dividends and stock repurchases in Chapter 14 so that students will already un- derstand stock repurchases when we discuss recapitalizations in Chapter 15.

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

Chapter 1: An Overview of Financial Management and the Financial Environment. We added a new box on globalization, “Columbus Was Wrong—

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the World Is Flat! And Hot, and Crowded,” and a new box on the global economic crisis, “Say Hello to the Global Economic Crisis!” We completely rewrote the sec- tion on financial securities, including a discussion of securitization, and added a new section on the global crisis. New figures showing the national debt, trade balances, federal budget deficits and the Case-Shiller real estate index help us better illustrate different aspects of the global crisis.

Chapter 2: Financial Statements, Cash Flow, and Taxes. A new opening vi- gnette shows the cash that several different companies generated and the different ways that they used the cash flow. We added a new box on the global economic crisis that explains the problems associates with off-balance-sheet assets, “Let’s Play Hide- and-Seek!” We added a new figure illustrating the uses of free cash flow. We now have two end-of-chapter spreadsheet problems, one focusing on the articulation between the income statement and statement of cash flows, and one focusing on free cash flow.

Chapter 3: Analysis of Financial Statements. We added a new box on marking to market, “The Price is Right! (Or Wrong!),” and a new box on international ac- counting standards, “The World Might be Flat, but Global Accounting is Bumpy! The Case of IFRS versus FASB.” We have included discussion of the price/EBITDA ratio, gross profit margin, and operating profit margin; we also explain how to use the statement of cash flows in financial analysis.

Chapter 4: Time Value of Money. We added three new boxes: (1) “Hints on Using Financial Calculators,” (2) “Variable Annuities: Good or Bad?”, and (3) “An Accident Waiting to Happen: Option Reset Adjustable Rate Mortgages.”

Chapter 5: Bonds, Bond Valuation, and Interest Rates. We added four new boxes related to the global economic crisis: (1) “Betting With or Against the U.S. Government: The Case of Treasury Bond Credit Default Swaps,” (2) “Insuring with Credit Default Swaps: Let the Buyer Beware!” (3) “Might the U.S. Treasury Bond Be Downgraded?” and (4) “Are Investors Rational?” We also added a new table summarizing corporate bond default rates and annual changes in ratings.

Chapter 6: Risk, Return, and the Capital Asset Pricing Model. The new open- ing vignette discusses the recent stock market and compares the market’s returns to GE’s returns. We added a new box on the risk that remains even for long-term investors, “What Does Risk Really Mean?” We added two additional boxes on risk, “How Risky Is a Large Portfolio of Stocks?” and “Another Kind of Risk: The Bernie Madoff Story.”

Chapter 7: Stocks, Stock Valuation, and Stock Market Equilibrium. A new opening vignette discusses buy- and sell-side analysts. We added a new box on be- havioral issues, “Rational Behavior vs. Animal Spirits, Herding, and Anchoring Bias.” We added a new section, “The Market Stock Price vs. Intrinsic Value.”

Chapter 8: Financial Options and Applications in Corporate Finance. We completely rewrote the description of the binomial option pricing model. In addition to the hedge portfolio, we also discuss replicating portfolios. We now provide the binomial formula and we show the complete solution to the 2-period model. To pro- vide greater continuity, the company used to illustrate the binomial example is now the same company used to illustrate the Black-Scholes model. Our discussion of put options now includes the Black-Scholes put formula.

Chapter 9: The Cost of Capital. We added a new figure to highlight the similari- ties and differences among capital structure weights based on book values, market

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values, and target values. We added a new box, “GE and Warren Buffett: The Cost of Preferred Stock.” We completely rewrote our discussion of the market risk pre- mium, which now includes the impact of stock repurchases on estimating the market risk premium. We also present data from surveys identifying the market risk premia used by CFOs and professors.

Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows. We added a new box, “Why NPV is Better than IRR.”

Chapter 11: Cash Flow Estimation and Risk Analysis. We now show how to use tornado diagrams in sensitivity analysis. We rewrote our discussion of Monte Carlo simulation and show how to conduct a simulation analysis without using add- ins but instead using only Excel’s built-in features (Data Tables and random number generators). We have included an example of replacement analysis and an example of a decision tree showing abandonment. We added a new box, “Are Bank Stress Tests Stressful Enough?”

Chapter 12: Financial Planning and Forecasting Financial Statements. It is difficult to do financial planning without using spreadsheet software, so we completely rewrote the chapter and explicitly integrated the text and the Excel Tool Kit model. We illustrate the ways that financial policies (i.e., dividend payout and capital structure choices) affect financial projections, including ways to ensure that balance sheets balance. The Excel Tool Kit model now shows a very simple way to incorporate financing feedback effects.

Chapter 13: Corporate Valuation, Value-Based Management, and Corporate Governance. The new opening vignette discusses the role of corporate governance in the global economic crisis. We also added three new boxes. The first describes corpo- rate governance issues at IBM, “Let’s Go to Miami! IBM’s 2009 Annual Meeting.” The second discusses leadership at bailout recipients, “Would the U.S. Government be an Effective Board Director?” The third discusses the 2009 proxy season, “Share- holder Reactions to the Crisis.”

Chapter 14: Distributions to Shareholders: Dividends and Repurchases. We consolidated the coverage of stock repurchases that had been spread over two chapters and located it here, which now precedes our discussion of capital structure in Chapter 15. We also use the FCF valuation model to illustrate the different impacts of stock repurchases versus dividend payments. We added two new boxes. The first discusses recent dividend cuts, “Will Dividends Ever Be the Same?” and the second discusses Sun Microsystem’s stock splits and recent reverse split, “Talk About a Split Personality!”

Chapter 15: Capital Structure Decisions. The new opening vignette discusses re- cent bankruptcies and Black & Decker efforts to reduce liquidity risk by refinancing short-term debt with long-term debt. Because the stock repurchases are now covered in the preceding chapter, we were able to improve our discussion of recapitalizations within the context of the FCF valuation model. We added a new box, “Deleveraging” that discusses the changes in leverage many companies and individuals are making in light of the global economic crisis.

Chapter 16: Working Capital Management. We reorganized the chapter so that we now discuss working capital holdings and financing before discussing the cash conversion cycle. We rewrote our coverage of the cash conversion cycle to explain the general concepts and then apply them to actual financial statement data.

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We added the box “Some Firms Operate with Negative Working Capital!” and a new section on the cost of cost of bank loans.

Chapter 17: Multinational Financial Management. We added a new opening vignette on the global economic crisis and its impact on world economies, foreign direct investment, and cross-border M&As. We added two new boxes, the first on regulating international bribery and taxation, “Greasing the Wheels of International Business.” The second new box discusses the wave of foreign companies partnering with Chinese banks to provide consumer finance services, “Consumer Finance in China.”

Chapter 18: Lease Financing. The new opening vignette discusses Virgin Atlan- tic’s order of 10 Airbus jets to be leased from AerCap. A new box addresses the FASB/IASB movement to capitalize all leases, “Off-Balance Sheet Financing: Is it Going to Disappear?”

Chapter 19: Hybrid Financing: Preferred Stock, Warrants, and Convertibles. The new opening vignette discusses the Treasury Department’s use of preferred stock and warrants to support troubled companies. A new box discusses the use of payment- in-kind preferred stock in the merger of Dow Chemical Company and Rohm & Haas, “The Romance Had No Chemistry, But It Had a Lot of Preferred Stock!”

Chapter 20: Initial Public Offerings, Investment Banking, and Financial Restructuring. The new opening vignette discusses three companies that recently raised capital via an initial public offering, a seasoned stock offering, and a debt offer- ing. We added a new section on investment banking activities. We added a new box on “Investment Banks and the Global Economic Crisis.”

Chapter 21: Mergers, LBOs, Divestitures, and Holding Companies. We added a section explaining how the stock-swap ratio is determined for mergers where the payment is in the form of the acquiring company’s stock.

Chapter 22: Bankruptcy, Reorganization, and Liquidation. The new opening vignette discusses the bankruptcies of Lehman Brothers, Washington Mutual, Chrys- ler, and General Motors. We added a new box on personal and small business bank- ruptcies, “A Nation of Defaulters?”.

Chapter 23: Derivatives and Risk Management. The new opening vignette discusses risk management at Koch Industries, Navistar, and Pepsi. We added a new box on “Value at Risk and Enterprise Risk Management.” Throughout the chapter we discuss the failure of risk management during the global economic crisis.

Chapter 24: Portfolio Theory, Asset Pricing Models, and Behavioral Finance. We added a box on the WSJ contest between dart-throwers and investors, “Skill or Luck?”. We expanded our discussion of the Fama-French 3-factor model and included a table showing returns of portfolios formed by sorting on size and the book- to-market ratio.

Chapter 25: Real Options. The new opening vignette discusses Honda’s flexible manufacturing plants.

Aplia Finance Aplia Finance, an interactive learning system, engages students in course concepts, ensures they practice on a regular basis, and helps them prepare to learn finance through a series of tutorials. Created by an instructor to help students excel, book-

xxiv Preface

specific problem sets have instant grades and detailed feedback, ensuring students have the opportunity to learn from and improve with every question.

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

Aplia Finance offers:

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

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

• News Analyses: Students connect course theories to real-world events by reading relevant news articles and answering graded questions about the article.

• Course Management System • Digital Textbook

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

Thomson ONE—Business School Edition Thomson ONE—Business School Edition is an online database that draws from the world acclaimed Thomson Financial data sources, including the SEC Disclosure, Datastream, First Call, and Worldscope databases. Now you can give your students the opportunity to practice with a business school version of the same Internet-based database that brokers and analysts around the world use every day. Thomson ONE— BSE provides (1) one-click download of financial statements to Excel, (2) data from domestic and international companies, (3) 10 years of financial data; and (4) one- click Peer Set analyses.

Many chapters have suggested problems based on data available at Thomson ONE—BSE. Here is a description of the data provided by Thomson ONE—BSE:

I/B/E/S Consensus Estimates. Includes consensus estimates—averages, means, and medians; analyst-by-analyst earnings coverage; analysts’ forecasts based on 15 industry standard measures; current and historic coverage for the selected 500 com- panies. Current coverage is five years forward plus historic data from 1976 for U.S. companies and from 1987 for international companies, with current data updated daily and historic data updated monthly.

Worldscope. Includes company profiles, financials, accounting results, and market per-share data for the selected 500 companies going back to 1980, all updated daily.

Disclosure SEC Database. Includes company profiles, annual and quarterly com- pany financials, pricing information, and earnings estimates for selected U.S. and Ca- nadian companies, annually from 1987, quarterly for the last 10 years, and monthly for prices, all updated weekly.

DataStream Pricing. Daily international pricing, including share price informa- tion (open, high, low, close, P/E) plus index and exchange rate data, for the last 10 years.

WWW To access Thomson ONE— BSE, go to http://tobsefin .swlearning.com and fol- low the instructions shown there. You will need the serial number that came on the card in your textbook.

Preface xxv

http://www.aplia.com/finance
http://tobsefin.swlearning.com
http://tobsefin.swlearning.com
ILX Systems Delayed Quotes. Includes 20-minute delayed quotes of equities and indices from U.S. and global tickers covering 130 exchanges in 25 developed countries.

Comtex Real-Time News. Includes current news releases.

SEC Edgar Filings and Global Image Source Filings. Includes regulatory and nonregulatory filings for both corporate and individual entities. Edgar filings are real-time and go back 10 years; image filings are updated daily and go back 7 years.

MAKE IT YOURS Your course is unique; create a casebook that reflects it. Let us help you put together a quality casebook simply, quickly, and affordably.

We want to help you focus on the most important thing – teaching. That’s why we have made this as simple as possible for you. We have aligned best-selling cases from our Klein/Brigham and Brigham/Buzzard series at the chapter level to Brigham/Ehr- hardt. We encourage you to visit http://www.cengage.com/custom/makeityours/ BrighamEhrhardt and select the cases to include in a custom case book. The cases are listed under each chapter title. To review cases, simply click on “view abstract” next to each case title. If you would like to review the full case, contact your Cengage Learning representative or fill out the form and we will contact you.

For more information about custom publishing options, visit www.cengage.com/ custom/.

THE INSTRUCTIONAL PACKAGE: AN INTEGRATED LEARNING SYSTEM Financial Management includes a broad range of ancillary materials designed to enhance students’ learning and to make it easier for instructors to prepare for and conduct classes. All resources available to students are of course also available to instructors, and instructors also have access to the course management tools.

Learning Tools Available for Students and Instructors The Cengage Global Economic Watch (GEW) Resource Center. This is your source for turning today’s challenges into tomorrow’s solutions. This online portal, available for free when bundled with the text, houses the most current and up- to-date content concerning the economic crisis. Organized by discipline, the GEC Resource Center offers the solutions instructors and students need in an easy-to-use format. Included are an overview and timeline of the historical events leading up to the crisis; links to the latest news and resources; discussion and testing content; an instructor feedback forum; and a Global Issues Database.

Study Guide. This supplement outlines the key sections of each chapter, and it provides students with a set of questions and problems similar to those in the text and in the Test Bank, along with worked-out solutions. Instructors seldom use the Study Guide themselves, but students often find it useful, so we recommend that instructors ask their bookstores to have copies available. Our bookstores generally have to reorder it, which attests to its popularity with students.

In addition to these printed resources and the items noted above, many other resources are available on the Web at Financial Management’s Web site. These ancil- laries include:

xxvi Preface

http://www.cengage.com/custom/makeityours/BrighamEhrhardt
http://www.cengage.com/custom/makeityours/BrighamEhrhardt
www.cengage.com/custom/
www.cengage.com/custom/
Excel Tool Kits. Proficiency with spreadsheets is an absolute necessity for all MBA students. With this in mind, we created Excel spreadsheets, called “Tool Kits,” for each chapter to show how the calculations used in the chapter were actually done. The Tool Kit models include explanations and screen shots that show students how to use many of the features and functions of Excel, enabling the Tool Kits to serve as self- taught tutorials.

An e-Library: Web Extensions and Web Chapters. Many chapters have Adobe PDF “appendices” that provide more detailed coverage of topics that were addressed in the chapter. In addition, these four specialized topics are covered in PDF web chapters: Banking Relationships, Working Capital Management Extensions, Pension Plan Management, and Financial Management in Not-for-Profit Businesses.

End-of-Chapter Spreadsheet Problems. Each chapter has a “Build a Model” prob- lem, where students start with a spreadsheet that contains financial data plus general instructions relating to solving a specific problem. The model is partially completed, with headings but no formulas, so the student must literally build a model. This struc- ture guides the student through the problem, minimizes unnecessary typing and data entry, and also makes it easy to grade the work, since all students’ answers are in the same locations on the spreadsheet. The partial spreadsheets for the “Build a Model” problems are available to students on the book’s Web site, while the completed models are in files on the Instructor’s portion of the Web site.

Thomson ONE—BSE Problem Sets. The book’s Web site has a set of problems that require accessing the Thomson ONE—Business School Edition Web data. Using real world data, students are better able to develop the skills they will need in the real world.

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

Course Management Tools Available only to Instructors Instructors have access to all of the materials listed above, plus additional course manage- ment tools. These are available at Financial Management’s Instructor companion Web site and on the Instructor’s Resource CD. These materials include:

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

PowerPoint Slides. There is a Mini Case at the end of each chapter. These cases cover all the essential issues presented in the chapter, and they provide the structure for our class lectures. For each Mini Case, we developed a set of PowerPoint slides that present graphs, tables, lists, and calculations for use in lectures. Although based on the Mini Cases, the slides are completely self-contained in the sense that they can be used for lectures regardless of whether students are required to read the mini cases. Also, instructors can easily customize the slides, and they can be converted quickly into any PowerPoint Design Template.1 Copies of these files are on the Instruc- tor’s Web site.

1To convert into PowerPoint, select Format, Apply Design Template, and then pick any template. Always double-check the conversion; some templates use differently sized fonts, which can cause some slide titles to run over their allotted space.

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Mini Case Spreadsheets. In addition to the PowerPoint slides, we also provide Excel spreadsheets that do the calculations required in the Mini Cases. These spreadsheets are similar to the Tool Kits except (a) the numbers correspond to the Mini Cases rather than the chapter examples, and (b) we added some features that make it possi- ble to do what-if analysis on a real-time basis in class. We usually begin our lectures with the PowerPoint presentation, but after we have explained a basic concept we “toggle” to the mini case Excel file and show how the analysis can be done in Excel.2

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

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

Solutions to Thomson ONE—BSE Problem Sets. The Thomson ONE—BSE problems set require students to use real world data. Although the solutions change daily as the data change, we provide instructors with “representative” answers.

Test Bank. The Test Bank contains more than 1,200 class-tested questions and pro- blems. Information regarding the topic and degree of difficulty, along with the com- plete solution for all numerical problems, is provided with each question. The Test Bank is available in three forms: (1) in a printed book; (2) in Microsoft Word files; and (3) in a computerized test bank software package, Exam View, which has many features that make test preparation, scoring, and grade recording easy, including the ability to generate different versions of the same problem. Exam View is easily able to export pools into Blackboard and WebCT.

Textchoice, the Cengage Learning Online Case Library. More than 100 cases written by Eugene F. Brigham, Linda Klein, and Chris Buzzard are now available via the Internet, and new cases are added every year. These cases are in a database that allows instructors to select cases and create their own customized casebooks. Most of the cases have accompanying spreadsheet models that, while not essential for working the case, do reduce number crunching and thus leave more time for students to con- sider conceptual issues. The models also illustrate how computers can be used to make better financial decisions. Cases that we have found particularly useful for the different chapters are listed in the end-of-chapter references. The cases, case solu- tions, and spreadsheet models can be previewed and ordered by instructors at http://www.textchoice2.com.

Cengage/South-Western will provide complimentary supplements or supplement packages to those adopters qualified under Cengage’s adoption policy. Please contact your sales representative to learn how you may qualify. If, as an adopter or potential user, you receive supplements you do not need, please return them to your sales representative.

2Note: To toggle between two open programs, such as Excel and PowerPoint, hold the Alt key down and hit the Tab key until you have selected the program you want to show.

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http://www.textchoice2.com
ACKNOWLEDGMENTS This book reflects the efforts of a great many people over a number of years. First, we would like to thank the following reviewers of the Twelfth Edition for their suggestions:

ANNE ANDERSON Lehigh University

OMAR M. BENKATO Ball State University

RAHUL BISHNOI Hofstra University

JONATHAN CLARKE Georgia Institute of Technology

SHARON H. GARRISON University of Arizona

HASSAN MOUSSAWI Wayne State University

A. JON SAXON Loyola Marymount University

JOSEPH VU DePaul University-Lincoln

In addition, we appreciate the many helpful comments and suggestions that we incorporated into this edition made by Richard M. Burns, Greg Faulk, John Harper, Robert Irons, Joe Walker, Barry Wilbratte, and Serge Wind.

Many professors and professionals who are experts on specific topics reviewed ear- lier versions of individual chapters or groups of chapters and we are grateful for their insights; in addition, we would like to thank those whose reviews and comments on earlier editions and companion books have contributed to this edition: Mike Adler, Syed Ahmad, Sadhana M. Alangar, Ed Altman, Mary Schary Amram, Bruce Anderson, Ron Anderson, Bob Angell, Vince Apilado, Henry Arnold, Nasser Arshadi, Bob Aubey, Abdul Aziz, Gil Babcock, Peter Bacon, Kent Baker, Tom Bankston, Les Barenbaum, Charles Barngrover, Michael Barry, Bill Beedles, Moshe Ben-Horim, Bill Beranek, Tom Berry, Bill Bertin, Roger Bey, Dalton Bigbee, John Bildersee, Eric Blazer, Russ Boisjoly, Keith Boles, Gordon R. Bonner, Geof Booth, Kenneth Boudreaux, Helen Bowers, Oswald Bowlin, Don Boyd, G. Michael Boyd, Pat Boyer, Ben S. Branch, Joe Brandt, Elizabeth Brannigan, Greg Brauer, Mary Broske, Dave Brown, Kate Brown, Bill Brueggeman, Kirt Butler, Robert Button, Chris Buzzard, Bill Campsey, Bob Carleson, Severin Carlson, David Cary, Steve Celec, Don Chance, Antony Chang, Susan Chaplinsky, Jay Choi, S. K. Choudhury, Lal Chugh, Maclyn Clouse, Margaret Considine, Phil Cooley, Joe Copeland, David Cordell, John Cotner, Charles Cox, David Crary, John Crockett, Roy Crum, Brent Dalrymple, Bill Damon, Joel Dauten, Steve Dawson, Sankar De, Miles Delano, Fred Dellva, Anand Desai, Bernard Dill, Greg Dimkoff, Les Dlabay, Mark Dorfman, Gene Drycimski, Dean Dudley, David Durst, Ed Dyl, Dick Edelman, Charles Edwards, John Ellis, Dave Ewert, John Ezzell, Richard Fendler, Michael Ferri, Jim Filkins, John Finnerty, Susan Fischer, Mark Flannery, Steven Flint, Russ Fogler, E. Bruce Frederickson, Dan French, Tina Galloway, Partha Gangopadhyay, Phil Gardial, Michael Garlington, Jim Garvin, Adam Gehr, Jim Gentry, Stuart Gillan, Philip Glasgo, Rudyard Goode, Myron Gordon, Walt Goulet, Bernie Grablowsky, Theoharry Grammatikos, Ed Grossnickle, John Groth, Alan Grunewald, Manak Gupta, Sam Hadaway, Don Hakala, Janet Hamilton, Sally Hamilton, Gerald Hamsmith, William Hardin, John Harris, Paul Hastings, Patty Hatfield, Bob Haugen, Steve Hawke, Del Hawley, Hal Heaton, Robert Hehre, John Helmuth, George Hettenhouse, Hans Heymann, Kendall Hill, Roger Hill, Tom Hindelang, Linda Hittle, Ralph Hocking, J. Ronald Hoffmeister, Jim Horrigan, John Houston, John Howe, Keith Howe, Hugh Hunter, Steve Isberg, Jim Jackson, Vahan Janjigian, Kurt Jesswein, Kose John, Craig Johnson,

Preface xxix

Keith Johnson, Steve Johnson, Ramon Johnson, Ray Jones, Manuel Jose, Gus Kalogeras, Mike Keenan, Bill Kennedy, Joe Kiernan, Robert Kieschnick, Rick Kish, Linda Klein, Don Knight, Dorothy Koehl, Theodor Kohers, Jaroslaw Komarynsky, Duncan Kretovich, Harold Krogh, Charles Kroncke, Lynn Phillips Kugele, Joan Lamm, P. Lange, Howard Lanser, Martin Laurence, Ed Lawrence, Richard LeCompte, Wayne Lee, Jim LePage, Ilene Levin, Jules Levine, John Lewis, James T. Lindley, Chuck Linke, Bill Lloyd, Susan Long, Judy Maese, Bob Magee, Ileen Malitz, Phil Malone, Terry Maness, Chris Manning, Terry Martell, D. J. Masson, John Mathys, John McAlhany, Andy McCollough, Tom McCue, Bill McDaniel, Robin McLaughlin, Jamshid Mehran, Ilhan Meric, Larry Merville, Rick Meyer, Stuart E. Michelson, Jim Millar, Ed Miller, John Mitchell, Carol Moerdyk, Bob Moore, Barry Morris, Gene Morris, Fred Morrissey, Chris Muscarella, Stu Myers, David Nachman, Tim Nantell, Don Nast, Bill Nelson, Bob Nelson, Bob Niendorf, Tom O’Brien, Dennis O’Connor, John O’Donnell, Jim Olsen, Robert Olsen, Frank O’Meara, David Overbye, R. Daniel Pace, Coleen Pantalone, Jim Pappas, Stephen Parrish, Pam Peterson, Glenn Petry, Jim Pettijohn, Rich Pettit, Dick Pettway, Hugo Phillips, John Pinkerton, Gerald Pogue, Ralph A. Pope, R. Potter, Franklin Potts, R. Powell, Chris Prestopino, Jerry Prock, Howard Puckett, Herbert Quigley, George Racette, Bob Radcliffe, Allen Rappaport, Bill Rentz, Ken Riener, Charles Rini, John Ritchie, Jay Ritter, Pietra Rivoli, Fiona Robertson, Antonio Rodriguez, E. M. Roussakis, Dexter Rowell, Mike Ryngaert, Jim Sachlis, Abdul Sadik, Thomas Scampini, Kevin Scanlon, Frederick Schadler, James Schallheim, Mary Jane Scheuer, Carl Schweser, John Settle, Alan Severn, Sol Shalit, Elizabeth Shields, Frederic Shipley, Dilip Shome, Ron Shrieves, Neil Sicherman, J. B. Silvers, Clay Singleton, Joe Sinkey, Stacy Sirmans, Jaye Smith, Steve Smith, Don Sorenson, David Speairs, Ken Stanly, John Stansfield, Ed Stendardi, Alan Stephens, Don Stevens, Jerry Stevens, G. Bennett Stewart, Mark Stohs, Glen Strasburg, Robert Strong, Philip Swensen, Ernie Swift, Paul Swink, Eugene Swinnerton, Robert Taggart, Gary Tallman, Dennis Tanner, Craig Tapley, Russ Taussig, Richard Teweles, Ted Teweles, Jonathan Tiemann, Sheridan Titman, Andrew Thompson, George Trivoli, George Tsetsekos, Alan L. Tucker, Mel Tysseland, David Upton, Howard Van Auken, Pretorious Van den Dool, Pieter Vanderburg, Paul Vanderheiden, David Vang, Jim Verbrugge, Patrick Vincent, Steve Vinson, Susan Visscher, John Wachowicz, Mark D. Walker, Mike Walker, Sam Weaver, Kuo Chiang Wei, Bill Welch, Gary R. Wells, Fred Weston, Norm Williams, Tony Wingler, Ed Wolfe, Larry Wolken, Don Woods, Thomas Wright, Michael Yonan, Zhong-guo Zhou, David Ziebart, Dennis Zocco, and Kent Zumwalt.

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

Our colleagues and our students at the Universities of Florida and Tennessee gave us many useful suggestions, and the Cengage/South-Western staff—especially Mike Guendelsberger, Scott Fidler, Jacquelyn Featherly, Nate Anderson, and Mike Reynolds—helped greatly with all phases of text development, production, and marketing.

xxx Preface

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

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

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

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

January 2010

Preface xxxi

P A R T 1 Fundamental Concepts of Corporate Finance

Chapter 1 An Overview of Financial Management and the Financial Environment

Chapter 2 Financial Statements, Cash Flow, and Taxes

Chapter 3 Analysis of Financial Statements

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C H A P T E R 1 AnOverview of Financial Management and the Financial Environment In a global beauty contest for companies, the winner is … Apple.

Or at least Apple is the most admired company in the world, according to Fortune magazine’s annual survey. The others in the global top ten are Berkshire Hathaway, Toyota, Google, Johnson & Johnson, Procter & Gamble, FedEx, Southwest Airlines, General Electric, and Microsoft. What do these companies have that separates them from the rest of the pack?

According to a survey of executives, directors, and security analysts, these companies have very high average scores across nine attributes: (1) innovativeness, (2) quality of management, (3) long-term investment value, (4) social responsibility, (5) employee talent, (6) quality of products and services, (7) financial soundness, (8) use of corporate assets, and (9) effectiveness in doing business globally. After culling weaker companies, the final rankings are then determined by over 3,700 experts from a wide variety of industries.

What do these companies have in common? First, they have an incredible focus on using technology to understand their customers, reduce costs, reduce inventory, and speed up product delivery. Second, they continually innovate and invest in ways to differentiate their products. Some are known for game-changing products, such as Apple’s touch screen iPhone or Toyota’s hybrid Prius. Others continually introduce small improvements, such as Southwest Airline’s streamlined boarding procedures.

In addition to their acumen with technology and customers, they are also on the leading edge when it comes to training employees and providing a workplace in which people can thrive.

In a nutshell, these companies reduce costs by having innovative production processes, they create value for customers by providing high- quality products and services, and they create value for employees by training and fostering an environment that allows employees to utilize all of their skills and talents.

Do investors benefit from this focus on processes, customers, and employees? During the most recent 5-year period, these ten companies posted an average annual stock return of 6.9%, which is not too shabby when compared with the −4.1% average annual return of the S&P 500. These superior returns are due to superior cash flow generation. But, as you will see throughout this book, a company can generate cash flow only if it also creates value for its customers, employees, and suppliers.

WWW See http://money.cnn.com/ magazines/fortune/ for updates on the ranking.

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

1.1 THE FIVE-MINUTE MBA Okay, we realize you can’t get an MBA in five minutes. But just as an artist quickly sketches the outline of a picture before filling in the details, we can sketch the key elements of an MBA education. The primary objective of an MBA program is to pro- vide managers with the knowledge and skills they need to run successful companies, so we start our sketch with some common characteristics of successful companies. In particular, all successful companies are able to accomplish two main goals:

1. All successful companies identify, create, and deliver products or services that are highly valued by customers—so highly valued that customers choose to purchase from them rather than from their competitors.

2. All successful companies sell their products/services at prices that are high en- ough to cover costs and to compensate owners and creditors for the use of their money and their exposure to risk.

It’s easy to talk about satisfying customers and investors, but it’s not so easy to ac- complish these goals. If it were, then all companies would be successful, and you wouldn’t need an MBA!

The Key Attributes of Successful Companies First, successful companies have skilled people at all levels inside the company, including leaders, managers, and a capable workforce.

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

Third, successful companies have enough funding to execute their plans and support their operations. Most companies need cash to purchase land, buildings, equipment, and materials. Companies can reinvest a portion of their earnings, but most growing companies must also raise additional funds externally by some combination of selling stock and/or borrowing in the financial markets.

Just as a stool needs all three legs to stand, a successful company must have all three attributes: skilled people, strong external relationships, and sufficient capital.

The MBA, Finance, and Your Career To be successful, a company must meet its first main goal: identifying, creating, and delivering highly valued products and services to its customers. This requires that it possess all three of the key attributes mentioned above. Therefore, it’s not surprising that most of your MBA courses are directly related to these attributes. For example, courses in economics, communication, strategy, organizational behavior, and human resources should prepare you for a leadership role and enable you to effectively man- age your company’s workforce. Other courses, such as marketing, operations man- agement, and information technology, increase your knowledge of specific disciplines, enabling you to develop the efficient business processes and strong exter- nal relationships your company needs. Portions of this finance course will address

resource The textbook’s Web site has tools for teaching, learning, and conducting financial research.

WWW Consult http://www .careers-in-finance.com for an excellent site containing information on a variety of business career areas, listings of current jobs, and other reference materials.

4 Part 1: Fundamental Concepts of Corporate Finance

http://www.careers-in-finance.com
http://www.careers-in-finance.com
raising the capital your company needs to implement its plans. In short, your MBA courses will give you the skills you need to help a company achieve its first goal: pro- ducing goods and services that customers want.

Recall, though, that it’s not enough just to have highly valued products and satis- fied customers. Successful companies must also meet their second main goal, which is generating enough cash to compensate the investors who provided the necessary cap- ital. To help your company accomplish this second goal, you must be able to evaluate any proposal, whether it relates to marketing, production, strategy, or any other area, and implement only the projects that add value for your investors. For this, you must have expertise in finance, no matter your major. Thus, finance is a critical part of an MBA education, and it will help you throughout your career.

Self-Test What are the goals of successful companies? What are the three key attributes common to all successful companies? How does expertise in finance help a company become successful?

1.2 THE CORPORATE LIFE CYCLE Many major corporations, including Apple Computer and Hewlett-Packard, began life in a garage or basement. How is it possible for such companies to grow into the giants we see today? No two companies develop in exactly the same way, but the fol- lowing sections describe some typical stages in the corporate life cycle.

Starting Up as a Proprietorship Many companies begin as a proprietorship, which is an unincorporated business owned by one individual. Starting a business as a proprietor is easy—one merely be- gins business operations after obtaining any required city or state business licenses. The proprietorship has three important advantages: (1) it is easily and inexpensively

THE GLOBAL ECONOMIC CRISIS

Say Hello to the Global Economic Crisis! Imagine a story of greed and reckless daring, of for- tunes made and fortunes lost, of enormous corpora- tions failing and even governments brought to the brink of ruin. No, this isn’t a box-office blockbuster, but instead is the situation facing the world’s financial markets and economies as we write this in mid-2009.

What exactly is the crisis? At the risk of oversimplifi- cation, many of the world’s individuals, financial institu- tions, and governments borrowed too much money and used those borrowed funds to make speculative in- vestments. As those investments are turning out to be worth less than the amounts owed by the borrowers, widespread bankruptcies, buyouts, and restructurings for both borrowers and lenders are occurring. This in turn is reducing the supply of available funds that finan-

cial institutions normally lend to creditworthy indivi- duals, manufacturers, and retailers. Without access to credit, consumers are buying less, manufacturers are producing less, and retailers are selling less—all of which leads to layoffs. Because of falling consumption, shrinking production, and higher unemployment, the National Bureau of Economic Research declared that the United States entered a recession in December 2007. In fact, this is a global downturn, and most econ- omists expect it to be severe and lengthy.

As we progress through this chapter and the rest of the book, we will discuss different aspects of the crisis. For real-time updates, go to the Global Economic Crisis (GEC) Resource Center at http://www.cengage.com/gec and log in.

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

http://www.cengage.com/gec
formed, (2) it is subject to few government regulations, and (3) its income is not sub- ject to corporate taxation but is taxed as part of the proprietor’s personal income.

However, the proprietorship also has three important limitations: (1) it may be difficult for a proprietorship to obtain the capital needed for growth; (2) the proprie- tor has unlimited personal liability for the business’s debts, which can result in losses that exceed the money invested in the company (creditors may even be able to seize a proprietor’s house or other personal property!); and (3) the life of a proprietorship is limited to the life of its founder. For these three reasons, sole proprietorships are used primarily for small businesses. In fact, proprietorships account for only about 13% of all sales, based on dollar values, even though about 80% of all companies are proprietorships.

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

Regarding liability, the partners can potentially lose all of their personal assets, even assets not invested in the business, because under partnership law, each partner is liable for the business’s debts. Therefore, in the event the partnership goes bank- rupt, if any partner is unable to meet his or her pro rata liability then the remaining partners must make good on the unsatisfied claims, drawing on their personal assets to the extent necessary. To avoid this, it is possible to limit the liabilities of some of the partners by establishing a limited partnership, wherein certain partners are des- ignated general partners and others limited partners. In a limited partnership, the limited partners can lose only the amount of their investment in the partnership,

Columbus Was Wrong—the World Is Flat! And Hot, and Crowded!

In his best-selling book The World Is Flat, Thomas L. Friedman argues that many of the barriers that long protected businesses and employees from global competition have been broken down by dramatic im- provements in communication and transportation tech- nologies. The result is a level playing field that spans the entire world. As we move into the information age, any work that can be digitized will flow to those able to do it at the lowest cost, whether they live in San Jose’s Silicon Valley or Bangalore, India. For physical pro- ducts, supply chains now span the world. For example, raw materials might be extracted in South America, fab- ricated into electronic components in Asia, and then used in computers assembled in the United States, with the final product being sold in Europe.

Similar changes are occurring in the financial mar- kets, as capital flows across the globe to those who can best use it. Indeed, China raised more money through initial public offerings than any other country in 2006, and the euro is becoming the currency of choice for denominating global bond issues.

Unfortunately, a dynamic world can bring runaway growth, which can lead to significant environmental problems and energy shortages. Friedman describes these problems in another bestseller, Hot, Flat, and Crowded. In a flat world, the keys to success are knowl- edge, skills, and a great work ethic. In a flat, hot, and crowded world, these factors must be combined with innovation and creativity to deal with truly global problems.

6 Part 1: Fundamental Concepts of Corporate Finance

while the general partners have unlimited liability. However, the limited partners typically have no control—it rests solely with the general partners—and their returns are likewise limited. Limited partnerships are common in real estate, oil, equipment leasing ventures, and venture capital. However, they are not widely used in general business situations because usually no one partner is willing to be the general partner and thus accept the majority of the business’s risk, and none of the others are willing to be limited partners and give up all control.

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

Many Owners: A Corporation Most partnerships have difficulty attracting substantial amounts of capital. This is generally not a problem for a slow-growing business, but if a business’s products or services really catch on, and if it needs to raise large sums of money to capitalize on its opportunities, then the difficulty in attracting capital becomes a real drawback. Thus, many growth companies, such as Hewlett-Packard and Microsoft, began life as a proprietorship or partnership, but at some point their founders decided to con- vert to a corporation. On the other hand, some companies, in anticipation of growth, actually begin as corporations. A corporation is a legal entity created under state laws, and it is separate and distinct from its owners and managers. This separation gives the corporation three major advantages: (1) unlimited life—a corporation can continue after its original owners and managers are deceased; (2) easy transferability of ownership interest—ownership interests are divided into shares of stock, which can be transferred far more easily than can proprietorship or partnership interests; and (3) limited liability—losses are limited to the actual funds invested.

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

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

The charter includes the following information: (1) name of the proposed corpo- ration, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of

1In the case of very small corporations, the limited liability may be fiction because lenders frequently re- quire personal guarantees from the stockholders.

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

directors, and (5) names and addresses of directors. The charter is filed with the sec- retary of the state in which the firm will be incorporated, and when it is approved, the corporation is officially in existence.2 After the corporation begins operating, quarterly and annual employment, financial, and tax reports must be filed with state and federal authorities.

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

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

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

Growing and Managing a Corporation Once a corporation has been established, how does it evolve? When entrepreneurs start a company, they usually provide all the financing from their personal resources, which may include savings, home equity loans, or even credit cards. As the corpora- tion grows, it will need factories, equipment, inventory, and other resources to sup- port its growth. In time, the entrepreneurs usually deplete their own resources and must turn to external financing. Many young companies are too risky for banks, so the founders must sell stock to outsiders, including friends, family, private investors (often called angels), or venture capitalists. If the corporation continues to grow, it may become successful enough to attract lending from banks, or it may even raise additional funds through an initial public offering (IPO) by selling stock to the public at large. After an IPO, corporations support their growth by borrowing from banks, issuing debt, or selling additional shares of stock. In short, a corporation’s ability to grow depends on its interactions with the financial markets, which we de- scribe in much more detail later in this chapter.

For proprietorships, partnerships, and small corporations, the firm’s owners are also its managers. This is usually not true for a large corporation, which means that large firms’ stockholders, who are its owners, face a serious problem. What is to pre- vent managers from acting in their own best interests, rather than in the best inter- ests of the stockholder/owners? This is called an agency problem, because managers are hired as agents to act on behalf of the owners. Agency problems can be addressed by a company’s corporate governance, which is the set of rules that control the company’s behavior towards its directors, managers, employees, shareholders, cred- itors, customers, competitors, and community. We will have much more to say about

2More than 60% of major U.S. corporations are chartered in Delaware, which has, over the years, pro- vided a favorable legal environment for corporations. It is not necessary for a firm to be headquartered, or even to conduct operations, in its state of incorporation, or even in its country of incorporation.

8 Part 1: Fundamental Concepts of Corporate Finance

agency problems and corporate governance throughout the book, especially in Chapters 13 and 14.3

Self-Test What are the key differences between proprietorships, partnerships, and corporations? Describe some special types of partnerships and corporations, and explain the differences among them.

1.3 THE PRIMARY OBJECTIVE OF THE CORPORATION: VALUE MAXIMIZATION Shareholders are the owners of a corporation, and they purchase stocks because they want to earn a good return on their investment without undue risk exposure. In most cases, shareholders elect directors, who then hire managers to run the corporation on a day-to-day basis. Because managers are supposed to be working on behalf of share- holders, they should pursue policies that enhance shareholder value. Consequently, throughout this book we operate on the assumption that management’s primary ob- jective is stockholder wealth maximization.

The market price is the stock price that we observe in the financial markets. We later explain in detail how stock prices are determined, but for now it is enough to say that a company’s market price incorporates the information available to investors. If the market price reflects all relevant information, then the observed price is also the intrinsic, or fundamental, price. However, investors rarely have all relevant informa- tion. For example, companies report most major decisions, but they sometimes withhold selected information to prevent competitors from gaining strategic advantages.

Unfortunately, some managers deliberately mislead investors by taking actions to make their companies appear more valuable than they truly are. Sometimes these ac- tions are illegal, such as those taken by the senior managers at Enron. Sometimes the actions are legal but are taken to push the current market price above its fundamental price in the short term. For example, suppose a utility’s stock price is equal to its fun- damental price of $50 per share. What would happen if the utility substantially re- duced its tree-trimming program but didn’t tell investors? This would lower current costs and thus boost current earnings and current cash flow, but it would also lead to major expenditures in the future when falling limbs damage the lines. If investors were told about the major repair costs facing the company, the market price would immediately drop to a new fundamental value of $45. But if investors were kept in the dark, they might misinterpret the higher-than-expected current earnings, and the market price might go up to $52. Investors would eventually understand the situ- ation when the company later incurred large costs to repair the damaged lines; when that happened, the price would fall to its fundamental value of $45.

Consider this hypothetical sequence of events. A company’s managers deceived inves- tors, and the price rose to $52 when it would have fallen to $45 if not for the deception. Of course, this benefited those who owned the stock at the time of the deception, in- cluding managers with stock options. But when the deception came to light, those

3The classic work on agency theory is Michael C. Jensen and William H. Meckling’s “Theory of the Firm, Managerial Behavior, Agency Costs, and Ownership Structure,” Journal of Financial Economics, Oc- tober 1976, 305–360. Another article by Jensen specifically addresses these issues; see “Value Maximiza- tion, Stakeholder Theory, and the Corporate Objective Function,” Journal of Applied Corporate Finance, Fall 2001, 8–21. For an overview of corporate governance, see Stuart Gillan, “Recent Developments in Corporate Governance: An Overview,” Journal of Corporate Finance, June 2006, 381–402.

Chapter 1: An Overview of Financial Management and the Financial Environment 9

stockholders who still owned the stock suffered a significant loss, ending up with stock worth less than its original fundamental value. If the managers cashed in their stock op- tions prior to this, then only the stockholders were hurt by the deception. Because the managers were hired to act in the interests of stockholders, their deception was a breach of their fiduciary responsibility. In addition, the managers’ deception would damage the company’s reputation, making it harder to raise capital in the future.

Therefore, when we say management’s objective should be to maximize stockholder wealth, we really mean it is to maximize the fundamental price of the firm’s common stock, not just the current market price. Firms do, of course, have other objectives; in partic- ular, the managers who make the actual decisions are interested in their own personal satisfaction, in their employees’ welfare, and in the good of their communities and of society at large. Still, for the reasons set forth in the following sections, maximizing in- trinsic stock value is the most important objective for most corporations.

Intrinsic Stock Value Maximization and Social Welfare If a firm attempts to maximize its intrinsic stock value, is this good or bad for society? In general, it is good. Aside from such illegal actions as fraudulent accounting, ex-

Ethics for Individuals and Businesses

A firm’s commitment to business ethics can be measured by the tendency of its employees, from the top down, to adhere to laws, regulations, and moral standards relating to product safety and quality, fair employment practices, fair marketing and selling prac- tices, the use of confidential information for personal gain, community involvement, and illegal payments to obtain business.

Ethical Dilemmas

When conflicts arise between profits and ethics, some- times legal and ethical considerations make the choice obvious. At other times the right choice isn’t clear. For example, suppose Norfolk Southern’s managers know that its trains are polluting the air, but the amount of pollution is within legal limits and further reduction would be costly, causing harm to their shareholders. Are the managers ethically bound to reduce pollution? Aren’t they also ethically bound to act in their share- holders’ best interests? This is clearly a dilemma.

Ethical Responsibility

Over the past few years, illegal ethical lapses have led to a number of bankruptcies, which have raised this question: Were the companies unethical, or was it just a few of their employees? Arthur Andersen, an account- ing firm, audited Enron, WorldCom, and several other

companies that committed accounting fraud. The U.S. Justice Department concluded that Andersen itself was guilty because it fostered a climate in which unethical behavior was permitted, and it built an incentive system that made such behavior profitable to both the perpe- trators and the firm itself. As a result, Andersen went out of business. Anderson was later judged to be not guilty, but by the time the judgment was rendered the company was already out of business. People simply did not want to deal with a tainted accounting firm.

Protecting Ethical Employees

If employees discover questionable activities or are given questionable orders, should they obey their bosses’ orders, refuse to obey those orders, or report the situation to a higher authority, such as the com- pany’s board of directors, its auditors, or a federal prosecutor? In 2002 Congress passed the Sarbanes- Oxley Act, with a provision designed to protect “whistle-blowers.” If an employee reports corporate wrongdoing and later is penalized, he or she can ask the Occupational Safety and Health Administration to investigate the situation, and if the employee was im- properly penalized, the company can be required to re- instate the person, along with back pay and a sizable penalty award. Several big awards have been handed out since the act was passed.

10 Part 1: Fundamental Concepts of Corporate Finance

ploiting monopoly power, violating safety codes, and failing to meet environmental standards, the same actions that maximize intrinsic stock values also benefit society. Here are some of the reasons:

1. To a large extent, the owners of stock are society. Seventy-five years ago this was not true, because most stock ownership was concentrated in the hands of a relatively small segment of society consisting of the wealthiest individuals. Since then, there has been explosive growth in pension funds, life insurance companies, and mutual funds. These institutions now own more than 61% of all stock, which means that most individuals have an indirect stake in the stock market. In addi- tion, more than 47% of all U.S. households now own stock or bonds directly, as compared with only 32.5% in 1989. Thus, most members of society now have an important stake in the stock market, either directly or indirectly. Therefore, when a manager takes actions to maximize the stock price, this improves the quality of life for millions of ordinary citizens.

2. Consumers benefit. Stock price maximization requires efficient, low-cost busi- nesses that produce high-quality goods and services at the lowest possible cost. This means that companies must develop products and services that consumers want and need, which leads to new technology and new products. Also, compa- nies that maximize their stock price must generate growth in sales by creating value for customers in the form of efficient and courteous service, adequate stocks of merchandise, and well-located business establishments.

People sometimes argue that firms, in their efforts to raise profits and stock prices, increase product prices and gouge the public. In a reasonably competi- tive economy, which we have, prices are constrained by competition and con- sumer resistance. If a firm raises its prices beyond reasonable levels, it will simply lose its market share. Even giant firms such as Dell and Coca-Cola lose business to domestic and foreign competitors if they set prices above the level necessary to cover production costs plus a “normal” profit. Of course, firms want to earn more, and they constantly try to cut costs, develop new pro- ducts, and so on, and thereby earn above-normal profits. Note, though, that if they are indeed successful and do earn above-normal profits, those very profits will attract competition, which will eventually drive prices down. So again, the main long-term beneficiary is the consumer.

3. Employees benefit. There are situations where a stock increases when a com- pany announces plans to lay off employees, but viewed over time this is the ex- ception rather than the rule. In general, companies that successfully increase stock prices also grow and add more employees, thus benefiting society. Note too that many governments across the world, including U.S. federal and state governments, are privatizing some of their state-owned activities by selling these operations to investors. Perhaps not surprisingly, the sales and cash flows of re- cently privatized companies generally improve. Moreover, studies show that newly privatized companies tend to grow and thus require more employees when they are managed with the goal of stock price maximization.

One of Fortune magazine’s key criteria in determining its list of most-admired companies is a company’s ability to attract, develop, and retain talented people. The results consistently show high correlations among admiration for a company, its ability to satisfy employees, and its creation of value for shareholders. Employ- ees find that it is both fun and financially rewarding to work for successful com- panies. Thus, successful companies get the cream of the employee crop, and skilled, motivated employees are one of the keys to corporate success.

WWW The Security Industry As- sociation’s Web site, http:// www.sifma.org, is a great source of information. To find data on stock owner- ship, go to its Web page, click on Research, choose Surveys, then Equity/Bond Ownership in America. You can purchase the most re- cent data, or look at the prior year for free.

Chapter 1: An Overview of Financial Management and the Financial Environment 11

http://www.sifma.org
http://www.sifma.org
Managerial Actions to Maximize Shareholder Wealth What types of actions can managers take to maximize shareholder wealth? To answer this question, we first need to ask, “What determines a firm’s value?” In a nutshell, it is a company’s ability to generate cash flows now and in the future.

We address different aspects of this in detail throughout the book, but we can lay out three basic facts now: (1) any financial asset, including a company’s stock, is valuable only to the extent that it generates cash flows; (2) the timing of cash flows matters—cash received sooner is better; and (3) investors are averse to risk, so all else equal, they will pay more for a stock whose cash flows are relatively certain than for one whose cash flows are more risky. Because of these three facts, managers can en- hance their firm’s value by increasing the size of the expected cash flows, by speeding up their receipt, and by reducing their risk.

The cash flows that matter are called free cash flows (FCF), not because they are free, but because they are available (or free) for distribution to all of the company’s investors, including creditors and stockholders. You will learn how to calculate free cash flows in Chapter 2, but for now you should know that free cash flows depend on three factors: (1) sales revenues, (2) operating costs and taxes, and (3) required new investments in operating capital. In particular, free cash flow is equal to:

FCF = Sales revenues − Operating costs − Operating taxes − Required new investments in operating capital

Brand managers and marketing managers can increase sales (and prices) by truly understanding their customers and then designing goods and services that customers want. Human resource managers can improve productivity through training and employee retention. Production and logistics managers can improve profit margins, reduce inventory, and improve throughput at factories by imple- menting supply chain management, just-in-time inventory management, and lean manufacturing. In fact, all managers make decisions that can increase free cash flows.

One of the financial manager’s roles is to help others see how their actions affect the company’s ability to generate cash flow and, hence, its intrinsic value. Financial managers also must decide how to finance the firm. In particular, they must choose the mix of debt and equity that should be used and the specific types of debt and eq- uity securities that should be issued. They must also decide what percentage of cur- rent earnings should be retained and reinvested rather than paid out as dividends. Along with these financing decisions, the general level of interest rates in the econ- omy, the risk of the firm’s operations, and stock market investors’ overall attitude to- ward risk determine the rate of return that is required to satisfy a firm’s investors. This rate of return from an investor’s perspective is a cost from the company’s point of view. Therefore, the rate of return required by investors is called the weighted average cost of capital (WACC).

The relationship between a firm’s fundamental value, its free cash flows, and its cost of capital is defined by the following equation:

Value¼ FCF1ð1þWACCÞ1 þ FCF2

ð1þWACCÞ2 þ FCF3

ð1þWACCÞ3þ …þ FCF∞ð1þWACCÞ∞ (1-1)

We will explain how to use this equation in later chapters, but for now note that (1) a growing firm often needs to raise external funds in the financial markets and

12 Part 1: Fundamental Concepts of Corporate Finance

(2) the actual price of a firm’s stock is determined in those markets. Therefore, the rest of this chapter focuses on financial markets.

Self-Test What should be management’s primary objective? How does maximizing the fundamental stock price benefit society? Free cash flow depends on what three factors? How is a firm’s fundamental value related to its free cash flows and its cost of capital?

1.4 AN OVERVIEW OF THE CAPITAL ALLOCATION PROCESS Businesses often need capital to implement growth plans; governments require funds to finance building projects; and individuals frequently want loans to purchase cars, homes, and education. Where can they get this money? Fortunately, there are some individuals and firms with incomes greater than their expenditures. In contrast to William Shakespeare’s advice, most individuals and firms are both borrowers and lenders. For example, an individual might borrow money with a car loan or a home mortgage but might also lend money through a bank savings account. In the aggre- gate, individuals are net savers and provide most of the funds ultimately used by non- financial corporations. Although most nonfinancial corporations own some financial securities, such as short-term Treasury bills, nonfinancial corporations are net bor- rowers in the aggregate. It should be no surprise to you that in the United States

Corporate Scandals and Maximizing Stock Price

The list of corporate scandals seems to go on forever: Sunbeam, Enron, ImClone, WorldCom, Tyco, Adelphia …. At first glance, it’s tempting to say, “Look what happens when managers care only about maximizing stock price.” But a closer look reveals a much different story. In fact, if these managers were trying to maximize stock price, they failed dismally, given the resulting values of these companies.

Although details vary from company to company, a few common themes emerge. First, managerial com- pensation was linked to the short-term performance of the stock price via poorly designed stock option and stock grant programs. This provided managers with a powerful incentive to drive up the stock price at the option vesting date without worrying about the future. Second, it is virtually impossible to take legal and eth- ical actions that drive up the stock price in the short term without harming it in the long term because the value of a company is based on all of its future free cash flows and not just cash flows in the immediate future. Because legal and ethical actions to quickly drive up the stock price didn’t exist (other than the

old-fashioned ones, such as increasing sales, cutting costs, or reducing capital requirements), these man- agers began bending a few rules. Third, as they ini- tially got away with bending rules, it seems that their egos and hubris grew to such an extent that they felt they were above all rules, so they began breaking even more rules.

Stock prices did go up, at least temporarily, but as Abraham Lincoln said, “You can’t fool all of the people all of the time.” As the scandals became public, the stocks’ prices plummeted, and in some cases the com- panies were ruined.

There are several important lessons to be learned from these examples. First, people respond to incen- tives, and poorly designed incentives can cause disas- trous results. Second, ethical violations usually begin with small steps, so if stockholders want managers to avoid large ethical violations, then they shouldn’t let them make the small ones. Third, there is no shortcut to creating lasting value. It takes hard work to increase sales, cut costs, and reduce capital requirements, but this is the formula for success.

Chapter 1: An Overview of Financial Management and the Financial Environment 13

federal, state, and local governments are also net borrowers in the aggregate (although many foreign governments, such as those of China and oil-producing countries, are actually net lenders). Banks and other financial corporations raise money with one hand and invest it with the other. For example, a bank might raise money from individuals in the form of a savings account and then lend most of that money to business customers. In the aggregate, financial corporations borrow slightly more than they lend.

Transfers of capital between savers and those who need capital take place in three different ways. Direct transfers of money and securities, as shown in Panel 1 of Figure 1-1, occur when a business (or government) sells its securities directly to savers. The business delivers its securities to savers, who in turn provide the firm with the money it needs. For example, a privately held company might sell shares of stock directly to a new shareholder, or the U.S. government might sell a Treasury bond directly to an individual investor.

As shown in Panel 2, indirect transfers may go through an investment banking house such as Goldman Sachs, which underwrites the issue. An underwriter serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which in turn sells these same securities to savers. Because new securities are involved and the corporation receives the proceeds of the sale, this is a “primary” market transaction.

Transfers can also be made through a financial intermediary such as a bank or mutual fund, as shown in Panel 3. Here the intermediary obtains funds from savers in exchange for its own securities. The intermediary then uses this money to pur- chase and then hold businesses’ securities. For example, a saver might give dollars to a bank and receive a certificate of deposit, and then the bank might lend the money to a small business, receiving in exchange a signed loan. Thus, intermediaries literally create new types of securities.

F IGURE 1-1 Diagram of the Capital Allocation Process

1. Direct Transfers

2. Indirect Transfers through Investment Bankers

3. Indirect Transfers through a Financial Intermediary

Business’s Securities

Dollars

Investment Banking Houses

Financial Intermediary

Business’s Securities

Dollars

Business’s Securities

Dollars

Business’s Securities

Dollars

Intermediary’s Securities

Dollars

Business

Business

Business

Savers

Savers

Savers

14 Part 1: Fundamental Concepts of Corporate Finance

There are three important characteristics of the capital allocation process. First, new financial securities are created. Second, financial institutions are often involved. Third, allocation between providers and users of funds occurs in financial markets. The following sections discuss each of these characteristics.

Self-Test Identify three ways that capital is transferred between savers and borrowers. Distinguish between the roles played by investment banking houses and financial intermediaries.

1.5 FINANCIAL SECURITIES The variety of financial securities is limited only by human creativity, ingenuity, and governmental regulations. At the risk of oversimplification, we can classify most fi- nancial securities by the type of claim and the time until maturity. In addition, some securities actually are created from packages of other securities. We discuss the key aspects of financial securities in this section.

Type of Claim: Debt, Equity, or Derivatives Financial securities are simply pieces of paper with contractual provisions that entitle their owners to specific rights and claims on specific cash flows or values. Debt in- struments typically have specified payments and a specified maturity. For example, an Alcoa bond might promise to pay 10% interest for 30 years, at which time it pro- mises to make a $1,000 principal payment. If debt matures in more than a year, it is called a capital market security. Thus, the Alcoa bond in this example is a capital mar- ket security.

If the debt matures in less than a year, it is a money market security. For example, Home Depot might expect to receive $300,000 in 75 days, but it needs cash now. Home Depot might issue commercial paper, which is essentially an IOU. In this exam- ple, Home Depot might agree to pay $300,000 in 75 days in exchange for $297,000 today. Thus, commercial paper is a money market security.

Equity instruments are a claim upon a residual value. For example, Alcoa’s stock- holders are entitled to the cash flows generated by Alcoa after its bondholders, cred- itors, and other claimants have been satisfied. Because stock has no maturity date, it is a capital market security.

Notice that debt and equity represent claims upon the cash flows generated by real assets, such as the cash flows generated by Alcoa’s factories and operations. In contrast, derivatives are securities whose values depend on, or are derived from, the values of some other traded assets. For example, options and futures are two impor- tant types of derivatives, and their values depend on the prices of other assets. An option on Alcoa stock or a futures contract to buy pork bellies are examples of deri- vatives. We discuss options in Chapter 8 and in Web Extension 1A, which provides a brief overview of options and other derivatives.

Some securities are a mix of debt, equity, and derivatives. For example, preferred stock has some features like debt and some like equity, while convertible debt has both debt-like and option-like features.

We discuss these and other financial securities in detail later in the book, but Table 1-1 provides a summary of the most important conventional financial securities. We discuss rates of return later in this chapter, but notice now in Table 1-1 that interest rates tend to increase with the maturity and risk of the security.

WWW You can access current and historical interest rates and economic data from the Federal Reserve Eco- nomic Data (FRED) site at http://www.stls.frb.org/ fred/.

resource For an overview of deri- vatives, see Web Exten- sion 1A on the textbook’s Web site.

Chapter 1: An Overview of Financial Management and the Financial Environment 15

http://www.stls.frb.org/fred/
http://www.stls.frb.org/fred/
Some securities are created from packages of other securities, a process called secu- ritization. The misuse of securitized assets is one of the primary causes of the global financial crisis, so we discuss securitization next.

Summary of Major F inancial Inst rumentsTABLE 1-1

INSTRUMENT MAJOR PARTICIPANTS RISK

ORIGINAL MATURITY

RATES OF RETURN ON 1/08/09a

U.S. Treasury bills Sold by U.S. Treasury Default-free 91 days to 1 year 0.41% Bankers’ acceptances A firm’s promise to pay,

guaranteed by a bank Low if strong bank guarantees

Up to 180 days 1.5%

Commercial paper Issued by financially secure firms to large investors

Low default risk Up to 270 days 0.28%

Negotiable certificates of deposit (CDs)

Issued by major banks to large investors

Depends on strength of issuer

Up to 1 year 1.58%

Money market mutual funds

Invest in short-term debt; held by individuals and businesses

Low degree of risk No specific matu- rity (instant liquidity)

1.27%

Eurodollar market time deposits

Issued by banks outside U.S.

Depends on strength of issuer

Up to 1 year 2.60%

Consumer credit loans Loans by banks/credit unions/finance companies

Risk is variable Variable Variable

Commercial loans Loans by banks to corporations

Depends on borrower Up to 7 years Tied to prime rate (3.25%) or LIBOR (2.02%)b

U.S. Treasury notes and bonds

Issued by U.S. government

No default risk, but price falls if interest rates rise

2 to 30 years 3.04%

Mortgages Loans secured by property Risk is variable Up to 30 years 5.02% Municipal bonds Issued by state and local

governments to indivi- duals and institutions

Riskier than U.S. govern- ment bonds, but exempt from most taxes

Up to 30 years 5.02%

Corporate bonds Issued by corporations to individuals and institutions

Riskier than U.S. govern- ment debt; depends on strength of issuer

Up to 40 yearsc 5.03%

Leases Similar to debt; firms lease assets rather than borrow and then buy them

Risk similar to corporate bonds

Generally 3 to 20 years

Similar to bond yields

Preferred stocks Issued by corporations to individuals and institutions

Riskier than corporate bonds

Unlimited 6% to 9%

Common stocksd Issued by corporations to individuals and institutions

Riskier than preferred stocks

Unlimited 9% to 15%

aData are from The Wall Street Journal (http://online.wsj.com) or the Federal Reserve Statistical Release (http://www.federalreserve .gov/releases/H15/update). Bankers’ acceptances assume a 3-month maturity. Money market rates are for the Merrill Lynch Ready Assets Trust. The corporate bond rate is for AAA-rated bonds. bThe prime rate is the rate U.S. banks charge to good customers. LIBOR (London Interbank Offered Rate) is the rate that U.K. banks charge one another.

cA few corporations have issued 100-year bonds; however, most have issued bonds with maturities of less than 40 years. dCommon stocks are expected to provide a “return” in the form of dividends and capital gains rather than interest. Of course, if you buy a stock, your actual return may be considerably higher or lower than your expected return.

16 Part 1: Fundamental Concepts of Corporate Finance

http://online.wsj.com
http://www.federalreserve.gov/releases/H15/update
http://www.federalreserve.gov/releases/H15/update
The Process of Securitization Many types of assets can be securitized, but we will focus on mortgages because they played such an important role in the global financial crisis. At one time, most mort- gages were made by savings and loan associations (S&Ls), which took in the vast majority of their deposits from individuals who lived in nearby neighborhoods. The S&Ls pooled these deposits and then lent money to people in the neighborhood in the form of fixed-rate mortgages, which were pieces of paper signed by borrowers promising to make specified payments to the S&L. The new homeowners paid prin- cipal and interest to the S&L, which then paid interest to its depositors and rein- vested the principal repayments in other mortgages. This was clearly better than having individuals lend directly to aspiring homeowners, because a single individual might not have enough money to finance an entire house nor the expertise to know if the borrower was creditworthy. Note that the S&Ls were government-chartered in- stitutions, and they obtained money in the form of immediately withdrawable depos- its and then invested most of it in the form of mortgages with fixed interest rates and on individual homes. Also, initially the S&Ls were not permitted to have branch operations—they were limited to one office so as to maintain their local orientation.

These restrictions had important implications. First, in the 1950s there was a mas- sive migration of people to the west, so there was a strong demand for funds in that area. However, the wealthiest savers were in the east. That meant that mortgage in- terest rates were much higher in California and other western states than in New York and the east. This created disequilibrium, something that can’t exist forever in financial markets.

Second, note that the S&Ls’ assets consisted mainly of long-term, fixed-rate mort- gages, but their liabilities were in the form of deposits that could be withdrawn im- mediately. The combination of long-term assets and short-term liabilities created another problem. If the overall level of interest rates increased, the S&Ls would have to increase the rates they paid on deposits or else savers would take their money elsewhere. However, the S&Ls couldn’t increase the rates on their outstanding mort- gages because these mortgages had fixed interest rates. This problem came to a head in the 1960s, when the Vietnam War led to inflation, which pushed up interest rates. At this point, the “money market fund” industry was born, and it literally sucked money out of the S&Ls, forcing many of them into bankruptcy.

The government responded by giving the S&Ls broader lending powers, permit- ting nationwide branching, and allowing them to obtain funds as long-term debt in addition to immediately withdrawable deposits. Unfortunately, these changes had an- other set of unintended consequences. S&L managers who had previously dealt with a limited array of investments and funding choices in local communities were sud- denly allowed to expand their scope of operations. Many of these inexperienced S&L managers made poor business decisions and the result was disastrous—virtually the entire S&L industry collapsed, with many S&Ls going bankrupt or being ac- quired in shotgun mergers with commercial banks.

The demise of the S&Ls created another financial disequilibrium—a higher de- mand for mortgages than the supply of available funds from the mortgage lending industry. Savings were accumulating in pension funds, insurance companies, and other institutions, not in S&Ls and banks, the traditional mortgage lenders.

This situation led to the development of “mortgage securitization,” a process whereby banks, the remaining S&Ls, and specialized mortgage originating firms would originate mortgages and then sell them to investment banks, which would bundle them into packages and then use these packages as collateral for bonds that could be sold to

Chapter 1: An Overview of Financial Management and the Financial Environment 17

pension funds, insurance companies, and other institutional investors. Thus, individual loans were bundled and then used to back a bond—a “security”—that could be traded in the financial markets.

Congress facilitated this process by creating two stockholder-owned but government- sponsored entities, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Fannie Mae and Freddie Mac were financed by issuing a relatively small amount of stock and a huge amount of debt.

To illustrate the securitization process, suppose an S&L or bank is paying its de- positors 5% but is charging its borrowers 8% on their mortgages. The S&L can take hundreds of these mortgages, put them in a pool, and then sell the pool to Fannie Mae. The mortgagees can still make their payments to the original S&L, which will then forward the payments (less a small handling fee) to Fannie Mae.

Consider the S&L’s perspective. First, it can use the cash it receives from selling the mortgages to make additional loans to other aspiring homeowners. Second, the S&L is no longer exposed to the risk of owning mortgages. The risk hasn’t disappeared—it has been transferred from the S&L (and its federal deposit insurers) to Fannie Mae. This is clearly a better situation for aspiring homeowners and per- haps also for taxpayers.

Fannie Mae can take the mortgages it just bought, put them into a very large pool, and sell bonds backed by the pool to investors. The homeowner will pay the S&L, the S&L will forward the payment to Fannie Mae, and Fannie Mae will use the funds to pay interest on the bonds it issued, to pay dividends on its stock, and to buy addi- tional mortgages from S&Ls, which can then make additional loans to aspiring homeowners. Notice that the mortgage risk has been shifted from Fannie Mae to the investors who now own the mortgage-backed bonds.

How does the situation look from the perspective of the investors who own the bonds? In theory, they own a share in a large pool of mortgages from all over the country, so a problem in a particular region’s real estate market or job market won’t affect the whole pool. Therefore, their expected rate of return should be very close to the 8% rate paid by the home-owning mortgagees. (It will be a little less due to han- dling fees charged by the S&L and Fannie Mae and to the small amount of expected losses from the homeowners who could be expected to default on their mortgages.) These investors could have deposited their money at an S&L and earned a virtually risk-free 5%. Instead, they chose to accept more risk in hopes of the higher 8% re- turn. Note too that mortgage-backed bonds are more liquid than individual mortgage loans, so the securitization process increases liquidity, which is desirable. The bottom line is that risk has been reduced by the pooling process and then allocated to those who are willing to accept it in return for a higher rate of return.

Thus, in theory it is a win–win–win situation: More money is available for aspiring homeowners, S&Ls (and taxpayers) have less risk, and there are opportunities for in- vestors who are willing to take on more risk to obtain higher potential returns. Al- though the securitization process began with mortgages, it is now being used with car loans, student loans, credit card debt, and other loans. The details vary for differ- ent assets, but the processes and benefits are similar to those with mortgage securiti- zation: (1) increased supplies of lendable funds; (2) transfer of risk to those who are willing to bear it; and (3) increased liquidity for holders of the debt.

Mortgage securitization was a win–win situation in theory, but as practiced in the last decade it has turned into a lose–lose situation. We will have more to say about securitization and the global economic crisis later in this chapter, but first let’s take a look at the cost of money.