RAYMOND M. BROOKS Oregon State University 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
PART I Fundamental Concepts and Basic Tools of Finance 1 1 Financial Management 1.1 The Cycle of Money 4 1.2 Overview of Finance Areas 5 1.3 Financial Markets 6 1.4 The Finance Manager and Financial Management 7 1.5 Objective of the Finance Manager 9 Profit Maximization 9 Maximizing Current Stock Price 9 1.6 Internal and External Players 10 1.7 The Legal Forms of Business 12 Proprietorship 12 Partnership 12 Corporations 13 Hybrid Corporations 14 Not-for-Profit Corporations 14 1.8 The Financial Management Setting: The Agency Model 14 1.9 Corporate Governance and Business Ethics 18 FINANCE FOLLIES The Financial Meltdown of 2008 19 1.10 Why Study Finance? 20 PUTTING FINANCE TO WORK "Now Hiring" 21 Key Terms 22 Questions 22 Prepping for Exams 23 MINI-CASE Richards' Tree Farm Grows Up 25 L Financial Statements 27 2.1 Financial Statements 28 The Balance Sheet 28 The Income Statement 31 Statement of Retained Earnings 33 2.2 Cash Flow Identity 34 The First Component: Cash Flow from Assets 35 The Second Component: Cash Flow to Creditors 36 The Third Component: Cash Flow to Owners 36 Putting It All Together: The Cash Flow Identity 36 2.3 Financial Performance Reporting 37 Regulation Fair Disclosure 37 Notes to the Financial Statements 37 2.4 Financial Statements on the Internet 38 PUTTING FINANCE TO WORK Look Before You Leap 41 Key Terms 42 Questions 42 Prepping for Exams 42 Problems 44 MINI-CASE Hudson Valley Realty 48 The Time Value of Money (Part 1) 51 3.1 Future Value and the Compounding of Interest 52 The Single-Period Scenario 52 The Multiple-Period Scenario 52 Methods of Solving Future Value Problems 53 3.2 Present Value and Discounting 57 The Single-Period Scenario 57 The Multiple-Period Scenario 58 The Use of Time Lines 60 3.3 One Equation and Four Variables 60 3.4 Applications of the Time Value of Money Equation 62 PUTTING FINANCE TO WORK Sports Agent 67 3.5 Doubling of Money: The Rule of 72 68 Key Terms 69 Questions 69 xx
A very good job in making the concept of financ oftvm early in the text. The author Jidso The explanation of bond pricingand yieldcdlciilc f^' -iv rji Prepping for Exams 70 Problems 72 MINI-CASE Richards' Tree Farm, Inc.: The Continuing Saga 77 4 The Time Value of Money (Part 2) 79 4.1 Future Value of Multiple Payment Streams 80 4.2 Future Value of an Annuity Stream 81 Future Value of an Annuity: An Application 83 4.3 Present Value of an Annuity 85 PUTTING FINANCE TO WORK Modeling the Future with Actuarial Science 87 4.4 Annuity Due and Perpetuity 88 Perpetuity 90 4.5 Three Payment Methods 90 Interest and Principal at the Maturity of Loan (Discount Loan) 91 Interest As You Go, Principal at Maturity of Loan (Interest-Only Loan) 91 Interest and Principal As You Go (Amortized Loan) 91 4.6 Amortization Schedules 93 4.7 Waiting Time and Interest Rates for Annuities 94 4.8 Solving a Lottery Problem 96 4.9 Ten Important Points about the TVM Equation 99 Key Terms 100 Questions 100 Prepping for Exams 101 Problems 102 MINI-CASE Fitchminster Injection Molding, Inc.: Rose Climbs High 109 5 Interest Rates ill 5.1 How Interest Rates Are Quoted: Annual and Periodic Interest Rates 112 5.2 Effect of Compounding Periods on the Time Value of Money Equations 114 5.3 Consumer Loans and Amortization Schedules 118 5.4 Nominal and Real Interest Rates 122 5.5 Risk-Free Rate and Premiums 124 Maturity Premiums 126 5.6 A Brief History of Interest Rates and Inflation in the United States 128 Key Terms 130 Questions 130 Prepping for Exams 131 Problems 133 MINI-CASE Sweetening the Deal: Lott Brothers Developers 137 PART II Valuing Stocks and Bonds and Understanding Risk and Return 139 O Bonds and Bond Valuation 141 6.1 Application of the Time Value of Money Tool: Bond Pricing 142 Key Components of a Bond 142 Pricing a Bond in Steps 143 6.2 Semiannual Bonds and Zero-Coupon Bonds 146 Pricing Bonds after Original Issue 148 Zero-Coupon Bonds 150 Amortization of a Zero-Coupon Bond 151 6.3 Yields and Coupon Rates 153 The First Interest Rate: Yield to Maturity 153 The "Other" Interest Rate: Coupon Rate 155 Relationship of Yield to Maturity and Coupon Rate 155 6.4 Bond Ratings 156 6.5 Some Bond History and More Bond Features 160 6.6 U.S. Government Bonds 163 xxi
PUTTING FINANCE TO WORK Municipal Manager 164 Pricing a U.S. Government Note or Bond 165 Pricing a Treasury Bill 165 Key Terms 167 Questions 168 Prepping for Exams 168 Problems 170 MINI-CASE Bay Path Cranberry Products 173 / Stocks and Stock Valuation 175 7.1 Characteristics of Common Stock 176 Ownership 176 Claim on Assets and Cash Flow (Residual Claim) 176 Vote (Voice in Management) 176 No Maturity Date 177 Dividends and Their Tax Effect 177 Authorized, Issued, and Outstanding Shares 177 Treasury Stock 178 Preemptive Rights 178 7.2 Stock Markets 178 Primary Markets 178 Secondary Markets: How Stocks Trade 180 Bull Markets and Bear Markets 180 7.3 Stock Valuation 181 The Constant Dividend Model with an Infinite Horizon 183 The Constant Dividend Model with a Finite Horizon 184 The Constant Growth Dividend Model with an Infinite Horizon 186 The Constant Growth Dividend Model with a Finite Horizon 188 Nonconstant Growth Dividends 190 FINANCE FOLLIES Irrational Expectations: Bulbs and Bubbles 191 7.4 Dividend Model Shortcomings 192 7.5 Preferred Stock 195 7.6 Efficient Markets 196 Operational Efficiency 196 Informational Efficiency 196 Key Terms 198 Questions 198 Prepping for Exams 198 Problems 200 MINI-CASE Lawrence's Legacy: Part 1 204 O Risk and Return 207 8.1 Returns 208 Dollar Profits and Percentage Returns 208 Converting Holding Period Returns to Annual Returns 209 Extrapolating Holding Period Returns 211 8.2 Risk (Certainty and Uncertainty) 211 FINANCE FOLLIES "Dangerous to Your Wealth": Is Investingjust Gambling? 212 8.3 Historical Returns 213 8.4 Variance and Standard Deviation as a Measure of Risk 217 Normal Distributions 219 8.5 Returns in an Uncertain World (Expectations and Probabilities) 221 FINANCE FOLLIES "Scam of the Century": Bernie Madoff and the $50 Billion Fraud 222 Determining the Probabilities of All Potential Outcomes 223 8.6 The Risk-and-Return Trade-off 225 Investment Rules 226 8.7 Diversification: Minimizing Risk or Uncertainty 227 When Diversification Works 229 Adding More Stocks to the Portfolio: Systematic and Unsystematic Risk 231 8.8 Beta: The Measure of Risk in a Well-Diversified Portfolio 232 8.9 The Capital Asset Pricing Model and the Security Market Line 233 The Capital Asset Pricing Model (CAPM) 234 Application of the SML 236 xxii
Vv Capital budgeting: * * Just exactly what I like to cover in On int Cashflowestimation: Logical, easy to read; atid a Key Terms 238 Questions 238 Prepping for Exams 239 Problems 241 MINI-CASE Lawrence's Legacy: Part 2 247 PART III Capital Budgeting 249 y Capital Budgeting Decision Models 251 9.1 Short-Term and Long-Term Decisions 252 FINANCE FOLLIES IBM Exits the Consumer Software Market: Misreading Future Cash Flows 253 9.2 Payback Period 254 Discounted Payback Period 256 9.3 Net Present Value 257 Mutually Exclusive versus Independent Projects 259 Unequal Lives of Projects 261 Net Present Value Example: Equation and Calculator Function 263 9.4 Internal Rate of Return 264 Appropriate Discount Rate or Hurdle Rate 266 Problems with the Internal Rate of Return 267 PUTTING FINANCE TO WORK Marketing and Sales: Your Product = Your Customer's Capital Budgeting Decision 268 Multiple Internal Rates of Return 269 Reinvestment Rate 270 Modified Internal Rate of Return 273 9.5 Profitability Index 275 9.6 Overview of Six Decision Models 276 Capital Budgeting Using a Spreadsheet 278 Key Terms 280 Questions 280 Prepping for Exams 280 Problems 282 MINI-CASE BioCom, Inc. 288 1 0 Cash Flow Estimation 291 10.1 The Importance of Cash Flow 292 10.2 Estimating Cash Flow for Projects: Incremental Cash Flow 293 Sunk Costs 294 Opportunity Costs 294 Erosion Costs 295 Synergy Gains 297 Working Capital 297 FINANCE FOLLIES Boston's "Big Dig" Gets Dug Under 299 10.3 Capital Spending and Depreciation 300 Modified Accelerated Cost Recovery System 301 10.4 Cash Flow and the Disposal of Capital Equipment 304 10.5 Projected Cash Flow for a New Product 305 Key Terms 310 Questions 310 Prepping for Exams 310 Problems 312 MINI-CASE Charbridge Office Furniture: Part 1, A New Product Line? 316 11 The Cost of Capital 319 11.1 The Cost of Capital: A Starting Point 320 11.2 Components of the Weighted Average Cost of Capital 322 Debt Component 323 Preferred Stock Component 324 Equity Component 325 Retained Earnings 327 11.3 Weighting the Components: Book Value or Market Value? 328 Book Value 328 Adjusted Weighted Average Cost of Capital 330 Market Value 330 XXIU
Cathy Goldberg, University of San Francisco ^^-^^^^P 11 "* 5 receivable management Warren Palmer, Beloit College 11.4 Using the Weighted Average Cost of Capital in a Budgeting Decision 331 Individual Weighted Average Cost of Capital for Individual Projects 332 11.5 Selecting Appropriate Betas for Projects 335 11.6 Constraints on Borrowing and Selecting Projects for the Portfolio 336 Key Terms 338 Questions 338 Prepping for Exams Problems 341 339 MINI-CASE Charbridge Office Furniture: Part 2, A Fresh Look at the WACC 347 PART IV Financial Planning and Evaluating Performance 349 1L Forecasting and Short-Term Financial Planning 351 12.1 Sources and Uses of Cash 352 12.2 Cash Budgeting and the Sales Forecast 354 Cash Inflow from Sales 356 Other Cash Receipts 357 12.3 Cash Outflow from Production 358 12.4 The Cash Forecast: Short-Term Deficits and Short-Term Surpluses 359 Funding Cash Deficits 360 Investing Cash Surpluses 362 12.5 Planning with Pro Forma Financial Statements 362 Pro Forma Income Statement 363 Pro Forma Balance Sheet 365 PUTTING FINANCE TO WORK Information Technology 368 Key Terms 369 Questions 369 Prepping for Exams 369 Problems 371 MINI-CASE Midwest Properties: Quarterly Forecasting 375 LD Working Capital Management 379 13.1 The Cash Conversion Cycle 380 Average Production Cycle 382 Average Collection Cycle 383 Average Payment Cycle 384 Putting It All Together: The Cash Conversion Cycle 384 13.2 Managing Accounts Receivable and Setting Credit Policy 385 Collecting Accounts Receivable 385 Credit: A Two-Sided Coin 386 Qualifying for Credit 387 Setting Payment Policy 389 Collecting Overdue Debt 391 13.3 The Float 392 Speeding Up the Collection (Shortening the Lag Time) 394 Slowing Down Payment (Lengthening the Lag Time) 395 13.4 Inventory Management: Carrying Costs and Ordering Costs 395 ABC Inventory Management 396 Redundant Inventory Items 396 Economic Order Quantity 397 13.5 The Effect of Working Capital on Capital Budgeting 402 PUTTING FINANCE TO WORK Operations Management 403 Inventories and Daily Operations 403 Key Terms 406 Questions 406 Prepping for Exams 406 Problems 409 MINI-CASE Cranston Dispensers Inc.: Parti 412 XXIV
1 4 Financial Ratios and Firm Performance 415 14.1 Financial Statements 416 Benchmarking 417 14.2 Financial Ratios 420 Short- Term Solvency: Liquidity Ratios 421 Long-Term Solvency: Solvency or Financial Leverage Ratios 423 Asset Management Ratios 424 Profitability Ratios 426 Market Value Ratios 427 DuPont Analysis 429 14.3 External Uses of Financial Statements and Industry Averages 430 Cola Wars 431 Industry Ratios 432 FINANCE FOLLIES Cooking the Books at Enron and WorldCom 434 Key Terms 435 / Questions 435 Prepping for Exams 435 Problems 437 MINI-CASE Cranston Dispensers Inc.: Part 2, Financial Statement Analysis 443 PART V Other Selected Finance Topics 447 1 5 Raising Capital 449 15.1 The Business Life Cycle 450 15.2 Borrowing for a Start-up and Growing Business 450 Personal Funds and Family Loans 450 Commercial Bank Loans 451 Commercial Banking Loans through the Small Business Administration 451 Angel Financing and Venture Capital 452 15.3 Borrowing for a Stable and Mature Business: Bank Loans 456 Straight Loans 456 Discount Loans 457 Letter of Credit or Line of Credit 458 Compensating Balance 458 15.4 Borrowing for a Stable and Mature Business: Selling Bonds 459 15.5 Borrowing for a Stable and Mature Business: Selling Stock 461 Initial Public Offerings and Underwriting 461 Registration, Prospectus, and Tombstone 463 The Marketing Process: Road Show 464 The Auction 465 The Aftermarket: Dealer in the Shares 466 PUTTING FINANCE TO WORK Corporate Law 468 15.6 Other Borrowing Options for a Mature Business 468 15.7 The Final Phase: Closing the Business 471 Straight Liquidation: Chapter 7 471 Reorganization: Chapter 11 472 Key Terms 473 Questions 473 Prepping for Exams 473 Problems 475 MINI-CASE AKWebDevelopers.com 478 ID Capital Structure 481 16.1 Capital Markets: A Quick Review 482 16.2 Benefits of Debt 484 Earnings per Share as a Measure of the Benefits of Borrowing 484 16.3 Break-Even Earnings for Different Capital Structures 486 16.4 Pecking Order 489 Firms Prefer Internal Financing First 489 Firms Choose to Issue Cheapest Security First and Use Equity as a Last Resort 489 XXV
Eric Hayden, University of Massachusetts, Boston 16.5 Modigliani and Miller on Optimal Capital Structure 491 Capital Structure in a World of No Taxes and No Bankruptcy 492 Capital Structure in a World of Corporate Taxes and No Bankruptcy 495 Debt and the Tax Shield 496 16.6 The Static Theory of Capital Structure 499 Bankruptcy 499 Static Theory of Capital Structure 500 FINANCE FOLLIES Long-Term Capital Management: The Really Smart Guys Get into Big Trouble 501 Key Terms 503 Questions 503 Prepping for Exams 503 Problems 505 MINI-CASE General Energy Storage Systems: How Much Debt and How Much Equity? 508 1 / Dividends, Dividend Policy, and Stock Splits 511 17.1 Cash Dividends 512 Buying and Selling Stock 512 Declaring and Paying a Cash Dividend: A Chronology 512 Different Types of Dividends 514' 17.2 Dividend Policy 516 Dividend Clienteles 516 Dividend Policy Irrelevance 517 Reasons Favoring a Low- or No-Dividend-Payout Policy 520 Reasons Favoring a High-Dividend-Payout Policy 521 Optimal Dividend Policy 522 17.3 Selecting a Dividend Policy 522 Some Further Considerations in the Selection of a Dividend Policy 524 17.4 Stock Dividends, Stock Splits, and Reverse Splits 525 Reasons for Stock Splits 526 Reverse Splits 527 17.5 Specialized Dividend Plans 527 Stock Repurchase 528 Dividend Reinvestment Plans 530 Key Terms 532 Questions 532 Prepping for Exams 533 Problems 534 MINI-CASE East Coast Warehouse Club 537 10 International Financial Management 541 18.1 Managing Multinational Operations 542 Cultural Risk 542 Business Risk 544 Political Risk 545 FINANCE FOLLIES Daimler-Chrysler: A Marriage Made in Heaven? 546 18.2 Foreign Exchange 547 Purchasing Power Parity 547 Currency Exchange Rates 549 Cross Rates 550 Arbitrage Opportunities 552 Forward Rates 553 Using Forward Rates 555 18.3 Transaction, Operating, and Translation Exposures 557 Transaction Exposure 557 Operating Exposure 558 Translation Exposure 559 18.4 Foreign Investment Decisions 559 Key Terms 562 Questions 563 Prepping for Exams 563 Problems 565 MINI-CASE Scholastic Travel Services Inc. 568 XXVI
Appendix 1 Future Value Interest Factors 570 Appendix 2 Present Value Interest Factors 572 Appendix 3 Future Value Interest Factors of an Annuity 574 Appendix 4 Present Value Interest Factors of an Annuity 576 Appendix 5 Answers to Prepping for Exam Questions 579 Glossary 589 Index 599 Credits 609 xxvu