Foundations of Finance

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1 Foundations of Finance The Logic and Practice of Financial Management Eighth Edition Global Edition Virginia Polytechnic Institute and State University,R. B. Pamplin Professor of Finance J Baylor University Professor of Finance Carr P. Collins Chair in Finance mfi) Petty Baylor University Professor of Finance W. W. Caruth Chair in Entrepreneurship PEARSON Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

2 Preface 19 PART1 The Scope and Environment of Financial Management 28 Financial Management and the Firm The Goal of the Firm Five Principles That Form the Foundations of Finance 30 Principle 1: Cash Flow Is What Matters 30 Principle 2: Money Has a.time Value 31 Principle 3: Risk Requires a Reward 31 Principle 4: Market Prices Are Generally Right 32 Principle 5: Conflicts of Interest Cause Agency Problems 33 The Current Global Financial Crisis 34 ' Avoiding Financial Crisis Back to the Principles 35 The Essential Elements of Ethics and Trust 36 The Role of Finance in Business 37 Why Study Finance? 37 The Role of the Financial Manager 38 The Legal Forms of Business Organization 39 Sole Proprietorships 39 Partnerships 39 Corporations 40 / Organizational Form and Taxes: the Double Taxation on Dividends S-Corporations and Limited Liability Companies (LLC) 40 Which Organizational Form Should Be Chosen? 41 Finance and the Multinational Firm: The New Role Chapter Summaries 42 Review Questions 44 Mini Case 44 Financial Markets and the Investment Banking System 46 Financing of Business: The Movement of Funds Through the Economy 47 Public Offerings Versus Private Placements 49 Primary Markets Versus Secondary Markets 49 The Money Market Versus the Capital Market 50 Spot Markets Versus Futures Markets 50 Stock Exchanges: Organized Security Exchanges Versus Over-the-Counter Markets, a Blurring Difference 51 Selling Securities to the Public 52 Functions 53 The Demise of the Stand-Alone Investment-Banking Industry 53 Distribution Methods 54 Private Debt Placements 56 Flotation Costs 57 Cautionary Tale: Forgetting Principle 5: Conflicts of Interest Cause Agency Problems 57 Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley Act 58 Rates of Return in the Financial Markets 58 Rates of Return over Long Periods 58 Interest Rate Levels in Recent Periods 59

3 Interest Rate Determinants in a Nutshell 62 Estimating Specific Interest Rates Using Risk Premiums 62 Real Risk-Free Interest Rate and the Risk-Free Interest Rate 63 Real and Nominal Rates of Interest 63 Can You Do It? 63 Did You Get It? 64 Inflation and Real Rates of Return: The Financial Analyst's Approach 65 Can You Do It? Solving for the Real Rate of Interest 65 Did You Get It? Solving for the Real Rate of Interest 66 The Term Structure of Interest Rates 67 Observing the Historical Term Structures of Interest Rates 67 Can You Do It? Solving for the Nominal Rate of Interest 67 Did You Get It? Solving for the Nominal Rate of Interest 68 What Explains the Shape of the Term Structure? 69 Chapter Summaries 10 Review Questions 13 Study Problems 13 Mini Case 75 A Review of Financial Statements 76 The Income Statement 78 Income Statement Illustrated: The Home Depot, Inc. 79 Home Depot's Common-Sized Income Statement 80 The Balance Sheet 82 Types of Assets 83 Types of Financing 85 Balance Sheet Illustrated: The Home Depot, Inc. 86 Working Capital 88 The Balance Sheet and Income Statement as One Picture 90 Can You Do It? Preparing an Income Statement and a Balance Sheet 91 Measuring Cash Flows 91 Profits Versus Cash Flows 91 Did You Get It? Preparing an Income Statement and a Balance Sheet 92 A Beginning Look: Determining Sources and Uses of Cash 93 Statement of Cash Flows 93 Finance at Work: Managing Your Cash Flows 94 Concluding Suggestions for Computing Cash Flows 100 Conclusions About Home Depot's Financial Position 100 Finance at Work: What Did Home Depot's Management Have to Say? 101 Can You Do It? Measuring Cash Flows 101 GAAPandlFRS 102 Did You Get It? Measuring Cash Flows 102 Income Taxes and Finance 102 Computing Taxable Income 103 Computing the Taxes Owed 103 Can You Do It? Computing a Corporation's Income Taxes 105 Accounting Malpractice and Limitations of Financial Statements 106 Did You Get It? Computing a Corporation's Income Taxes 106 Chapter Summaries 101 Review Questions 110* Study Problems 111 * Mini Case 118

4 Appendix 3A: Free Cash Flows 121 What Is a Free Cash Flow? 121 Computing Free Cash Flow 121 The Other Side of the Coin: Financing Cash Flows 124 Financing Cash Flows 124 A Concluding Thought 125 Appendix Summary 125 * Study Problems 125 Financial Statement Analysis 128 The Purpose of Financial Analysis 128 Finance at Work: Home Depot and Lowe's: The Histories 131 Measuring Key Financial Relationships 132 Question 1: How Liquid Is the Firm? Can It Pay Its Bills? 133 Question 2: Are the Firm's Managers Generating Adequate Operating Profits from the Company's Assets? 138 Question 3: How Is the Firm Financing Its Assets? 143 Question 4: Are the Firm's Managers Providing a Good Return on the Capital Provided by the Shareholders? 145 Question 5: Are the Firm's Managers Creating Shareholder Value? 148 The Limitations of Financial Ratio Analysis 154 Chapter Summaries 155 * Review Questions 158* Study Problems 158 * Mini Case 165 The Valuation of Financial Assets 168 Discounted Cash Flow Analytics 168 Compound Interest, Future, and Present Value 169 Using Timelines to Visualize Cash Flows 169 Techniques for Moving Money Through Time 173 Two Additional Types of Time Value of Money Problems 177 Applying Compounding to Things Other Than Money 178 Present Value 179 Cautionary Tale: Forgetting Principle 4: Market Prices Are Generally Right 181 Can You Do It? Solving for the Present Value with Two Flows in Different Years 182 Annuities 183 Compound Annuities 183 Did You Get It? Solving for the Present Value with Two Flows in Different Years 184 The Present Value of an Annuity 185 Annuities Due 187 Amortized Loans 188 Making Interest Rates Comparable 191 Finding Present and Future Values with Nonannual Periods 192 Can You Do It? How Much Can You Afford to Spend on a House? An Amortized Loan with Monthly Payments 192 Did You Get It? How Much Can You Afford to Spend on a House? An Amortized Loan with Monthly Payments 194 The Present Value of an Uneven Stream and Perpetuities 195 Perpetuities 196 Chapter Summaries 191 * Review Questions 200* Study Problems 200 Mini Case 206

5 6 Risk Analysis 208 Expected Return Defined and Measured 210 Can You Do It? Computing Expected Cash Flow and Expected Return 211 Risk Defined and Measured 212 Did You Get It? Computing Expected Cash Flow and Expected Return 213 Can You Do It? Computing the Standard Deviation 216 Finance at Work: A Different Perspective of Risk 216 Did You Get It? Computing the Standard Deviation 219 Rates of Return: The Investor's Experience 219 Risk and Diversification 220 Diversifying Away the Risk 221 Measuring Market Risk 222 Can You Do It? Estimating Beta 225 Measuring a Portfolio's Beta 228 Risk and Diversification Demonstrated 229 Did You Get It? Estimating Beta 230 The Investor's Required Rate of Return 232 The Required Rate of Return Concept 232 Measuring the Required Rate of Return 232 Finance at Work: Does Beta Always Work? 233 Can You Do It? Computing a Required Rate of Return 235 Did You Get It? Computing a Required Rate of Return 235 Chapter Summaries 235 * Review Questions 238 * Study Problems 239 * Mini Case 243 Interest Rates and Bond Valuatios 246 Types of Bonds 247 Debentures 247 Subordinated Debentures 248 Mortgage Bonds 248 Eurobonds 248 Convertible Bonds 248 Terminology and Characteristics of Bonds 249 Claims on Assets and Income 249 Par Value 249 Coupon Interest Rate 249 Maturity 250 Call Provision 250 Indenture 250 Bond Ratings 250 Finance at Work: J.C. Penney Credit Rating Reduced to Junk 251 Defining Value 252 What Determines Value? 253 Valuation: The Basic Process 254 Can You Do It? Computing an Asset's Value 255 Valuing Bonds 255 Did You Get It? Computing an Asset's Value 257 Can You Do It? Computing a Bond's Value 259

6 Did You Get It? Computing a Bond's Value 261 Bond Yields 261 Yield to Maturity 261 Current Yield 263 Bond Valuation: Three Important Relationships 264 Can You Do It? Computing the Yield to Maturity and Current Yield 265 Did You Get It? Computing the Yield to Maturity and Current Yield 266 Chapter Summaries 268 * Review Questions 272 * Study Problems 272 * Mini Case Equity Valuation 276 Preferred Stock 277 The Characteristics of Preferred Stock 277 Valuing Preferred Stock 279 Finance at Work: Reading a Stock Quote in the Wall Street Journal 280 Can You Do It? Valuing Preferred Stock 282 Common Stock 282 The Characteristics of Common Stock 283 Did You Get It? Valuing Preferred Stock 283 Valuing Common Stock 284 Can You Do It? Measuring Johnson & Johnson's Growth Rate 287 Did You Get It? Measuring Johnson & Johnson's Growth Rate 288 Can You Do It? Calculating,Common Stock Value 289 The Expected Rate of Return of Stockholders 289 Did You Get It? Calculating Common Stock Value 290 The Expected Rate of Return of Preferred Stockholders 290 The Expected Rate of Return of Common Stockholders 291 Can You Do It? Computing the Expected Rate of Return 292 Did You Get It? Computing the Expected Rate of Return 293 Chapter Summaries 294» Review Questions 291 Study Problems 291 Mini Case The Opportunity Cost of Capital 300 The Cost of Capital: Key Definitions and Concepts 301 Opportunity Costs, Required Rates of Return, and the Cost of Capital 301 Can You Do It? Determining How Flotation Costs Affect the Cost of Capital 302 The Firm's Financial Policy and the Cost of Capital 302 Determining the Costs of the Individual Sources of Capital 302 The Cost of Debt 303 Did You Get It? Determining How Flotation Costs Affect the Cost of Capital 303 Can You Do It? Calculating the Cost of Debt Financing 304 The Cost of Preferred Stock 305 Can You Do It? Calculating the Cost of Preferred Stock Financing 305 Did You Get It? Calculating the Cost of Debt Financing 306 The Cost of Common Equity 307 The Dividend Growth Model 307

7 Did You Get It? Calculating the Cost of Preferred Stock Financing 307 Issues in Implementing the Dividend Growth Model 308 The Capital Asset Pricing Model 309 Can You Do It? Calculating the Cost of New Common Stock Using the Dividend Growth Model 310 Can You Do It? Calculating the Cost of Common Stock Using the CAPM 310 Issues in Implementing the CAPM 310 Finance at Work: IPOs: Should a Firm Go Public? 311 Did You Get It? Calculating the Cost of New Common Stock Using the Dividend Growth Model 311 Did You Get It? Calculating the Cost of Common Stock Using the CAPM 312 The Weighted Average Cost of Capital 312 Capital Structure Weights 313 Calculating the Weighted Average Cost of Capital 313 Cautionary Tale: Forgetting Principle 3: Risk Requires a Reward 315 Calculating Divisional Costs of Capital 316 Estimating Divisional Costs of Capital 316 Using Pure Play Firms to Estimate Divisional WACCs 316 Finance at Work: The Pillsbury Company Adopts Eva with a Grassroots Education Program 319 Can You Do It? Calculating the Weighted Average Cost of Capital 319 Did You Get It? Calculating the Weighted Average Cost of Capital 319 Using a Firm's Cost of Capital to Evaluate New Capital Investments 320 Chapter Summaries 321 * Review Questions 323 Study Problems 324 * Mini Cases 328 PART 3 Investment in Long-Term Assets Capital Investment Decision Analysis-I 330 Finding Profitable Projects 331 Cautionary Tale: Forgetting Principle 3: Risk Requires a Reward and Principle 4: Market Prices Are Generally Right 332 : Capital-Budgeting Decision Criteria 333 The Payback Period 333 The Net Present Value 336 Using Spreadsheets to Calculate the Net Present Value 338 Can You Do It? Determining the NPV of a Project 339 The Profitability Index (Benefit-Cost Ratio) 339 Did You Get It? Determining the NPV of a Project 340 The Internal Rate of Return. 342 Can You Do It? Determining the IRR of a Project 344 Viewing the NPV-IRR Relationship: The Net Present Value Profile 345 Did You Get It? Determining the IRR of a Project 345 Complications with the IRR: Multiple Rates of Return 346 The Modified Internal Rate of Return (MIRR) Using Spreadsheets to Calculate the MIRR 350 Capital Rationing 351 The Rationale for Capital Rationing 351 Capital Rationing and Project Selection 352 Ranking Mutually Exclusive Projects 352 The Size-Disparity Problem 353 The Time-Disparity Problem 354 The Unequal-Lives Problem 355

8 I Ethics in Financial Management: The Financial Downside of Poor Ethical Behavior 358 Chapter Summaries 358 * Review Questions 361 * Study Problems 362 * Mini Case Capital Investment Decision Analysis Guidelines for Capital Budgeting 371 Use Free Cash Flows Rather Than Accounting Profits 371 Think Incrementally 371 Beware of Cash Flows Diverted from Existing Products 371 Look for Incidental or Synergistic Effects 372 Work in Working-Capital Requirements 372 Consider Incremental Expenses 372 Remember That Sunk Costs Are Not Incremental Cash Flows 373 Account for Opportunity Costs 373 Decide If Overhead Costs Are Truly Incremental Cash Flows 373 Ignore Interest Payments and Financing Flows 373 Finance at Work: Universal Studios 374 Calculating a Project's Free Cash Flows 374 What Goes into the Initial Outlay 374 What Goes into the Annual Free Cash Flows Over the Project's Life 375 What Goes into the Terminal Cash Flow 376 Calculating the Free Cash Flows 376 A Comprehensive Example: Calculating Free Cash Flows 380 Can You Do It? Calculating Operating Cash Flows 381 Did You Get It? Calculating Operating Cash Flows 383 Can You Do It? Calculating Free Cash Flows 383 Options in Capital Budgeting 384 The Option to Delay a Project 384 Did You Get It? Calculating'Free Cash Flows 384 The Option to Expand a Project 385 The Option to Abandon a Project 385 Options in Capital Budgeting: The Bottom Line 386 Risk and the Investment Decisions 386 What Measure of Risk Is Relevant in Capital Budgeting? 387 Measuring Risk for Capital-Budgeting Purposes with a Dose of Reality Is Systematic Risk All There Is? 388 Incorporating Risk into Capital Budgeting 388 Risk-Adjusted Discount Rates 389 Measuring a Project's Systematic Risk 391 Using Accounting Data to Estimate a Project's Beta 391 The Pure Play Method for Estimating Beta 392 Examining a Project's Risk Through Simulation 392 Conducting a Sensitivity Analysis Through Simulation 394 Chapter Summaries 395 Review Questions 391 * Study Problems 391 * Mini Case 402 Appendix 11 A: The Modified Accelerated Cost of Recovery System 404 What Does All This Mean? 405 Study Problems 405 Capital Structure and Dividend Policy Financial Leverage and Capital Structure Policy 406 Financial Leverage and Capital Structure Policy 408 Business Risk 408 Operating Risk 409

9 Finance at Work: Companies Increasingly Use Share Repurchases to Distribute Cash to Their Stockholders 455 A Financing or Investment Decision? 455 Practical Considerations The Stock Repurchase Procedure 455 Chapter Summaries 456 Review Questions 458 Study Problems 458 Mini Case 461 Working-Capital Management and International Business Finance Financial Forecasting and Planning 462 Financial Forecasting 463 The Sales Forecast 463 Forecasting Financial Variables 463 The Percent of Sales Method of Financial Forecasting 464 Analyzing the Effects of Profitability and Dividend Policy on DFN 465 Analyzing the Effects of Sales Growth on a Firm's DFN 466 Can You Do It? Percent of Sales Forecasting 467 Did You Get It? Percent of Sales Forecasting 468 Limitations of the Percent of Sales Forecasting Method 469 Constructing and Using a Cash Budget 470 Budget Functions 470 Ethics in Financial Management: To Bribe or Not to Bribe 471 The Cash Budget 471 Ethics in Financial Management: Being Honest About the Uncertainty of the Future 472 Chapter Summaries 473 * Review. Questions 474 Study Problems 475 Mini Case Managing Firm Liquidity 482 Managing Current Assets and Liabilities 483 The Risk-Return Trade-Off 483 The Advantages of Current Liabilities: Return 484 The Disadvantages of Current Liabilities: Risk 484 Determining the Appropriate Level of Working Capital 485 The Hedging Principles 485 Permanent and Temporary Assets 485 Temporary, Permanent, and Spontaneous Sources of Financing 486 The Hedging Principle: A Graphic Illustration 486 Cautionary Tale: Forgetting Principle 3: Risk Requires a Reward 486 The Cash Conversion Cycle 488 Can You Do It? Computing the Cash Conversion Cycle 488 Did You Get It? Computing the Cash Conversion Cycle 489 Estimating the Cost of Short-Term Credit Using the Approximate Cost-of-Credit Formula 490 Can You Do It? The Approximate Cost of Short-Term Credit 492 Sources of Short-Term Credit 492 Did You Get It? The Approximate Cost of Short-Term Credit 492 Finance at Work: Managing Working Capital by Trimming Receivables 493 Unsecured Sources: Accrued Wages and Taxes 493

10 Can You Do It? The Cost of Short-Term Credit (Considering Compounding Effects) 494 Unsecured Sources: Trade Credit 494 Did You Get It? The Cost of Short-Term Credit (Considering Compounding Effects) 495 Unsecured Sources: Bank Credit 495 Unsecured Sources: Commercial Paper 497 Secured Sources: Accounts-Receivable Loans 499 Secured Sources: Inventory Loans 501 Chapter Summaries 502 * Review Questions 505 * Study Problems International Corporate Finance 510 The Globalization of Product and Financial Markets 511 Foreign Exchange Markets and Currency Exchange Rates 512 Foreign Exchange Rates 513 Exchange Rates and Arbitrage 515 Asked and Bid Rates 515 Cross Rates 515 Can You Do It? Using the Spot Rate to Calculate a Foreign Currency Payment 515 Types of Foreign Exchange Transactions 516 Did You Get It? Using the Spot Rate to Calculate a Foreign Currency Payment 517 Exchange Rate Risk 518 Can You Do It? Computing a Percent-per-Annum Premium 518 Did You Get It? Computing a Percent-per-Annum Premium 519 Interest Rate Parity 520 Purchasing-Power Parity and the Law of One Price 521 The International Fisher Effect 522 Capital Budgeting for Direct Foreign Investment 523 Foreign Investment Risks 523 Chapter Summaries 524 ' Review Questions 526 Study Problems 521 * Mini Case 528 Web 17 Managing Short-Term Investments in Current Assets Available online at Web Appendix A Using a Calculator Available online at Glossary 531 Indexes 539

The Logic and Practice of Financial Management. Ninth Edition. Global Edition

Foundations of Finance The Logic and Practice of Financial Management Ninth Edition Global Edition Arthur J. Keown Virginia Polytechnic Institute and State University R. B. Pamplin Professor of Finance