Concise Sixth Edition

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Fundamentals of Financial Management: Concise Edition, 6th edition Eugene F. Brigham, Joel F. Houston

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The fi rst edition of Fundamentals was published 30 years ago. Since then, the body of fi nancial knowledge has expanded mightily, and this led us to continually add to the book. As Fundamentals got larger and larger, we heard more and more often that it was diffi cult to cover the entire book in a single term. Therefore, we asked our students and other professors for advice. Some said that we shouldn’t worry about the book’s size, because a larger, more complete book gives professors fl exi- bility in designing their courses, is a better reference for students after they have completed the course, and allows interested students to read chapters not covered in class on their own. Others disagreed, arguing that, as textbooks get larger, it becomes increasingly diffi cult for professors to develop a manageable syllabus, and it also forces students to buy a larger, more expensive text than they want or need. In the end, we concluded that both arguments have merit, so we decided to write a concise version for those who think a smaller, more concise textbook would better suit their needs.

When we fi rst created Concise, we debated between streamlining the book by covering all the topics but in less depth versus covering fewer topics but maintain- ing the depth and rigor of Fundamentals. We chose to retain the depth and level while eliminating some less essential topics. While the omitted topics are interest- ing and important, they are not critically important, and fi nance majors will study these topics later in their advanced courses.

STRUCTURE OF THE BOOK Our target audience is undergraduate students taking their fi rst, and often only, fi nance course. Some will decide to major in fi nance and go on to take courses in investments, money and capital markets, and advanced corporate fi nance. Others will choose marketing, management, or some other nonfi nance major. Still others will major in areas other than business and are taking fi nance and a few other business courses to gain information that will help them in law, real estate, or other fi elds.

Our challenge was to provide a book that serves all of these audiences well. Our conclusion was that we should focus on the core principles of fi nance, i.e., on basic topics such as the time value of money, risk analysis, and valuation. More- over, we concluded that we should address these topics from two points of view: (1) as an investor seeking to make intelligent investment choices and (2) as a busi- ness manager trying to maximize the value of his or her fi rm’s stock. Note that both investors and managers need to know the same set of principles, so the core topics are important to students regardless of what they choose to do after they fi nish the course.

In setting up the structure of the book, we fi rst listed the core topics in fi nance with which virtually everyone should be familiar. Included here are an overview of fi nancial markets, methods used to estimate the cash fl ows that determine assets’ values, the time value of money, the determinants of interest rates, the basics of risk analysis, and the basics of bond and stock valuation procedures. We cover these core topics in the fi rst nine chapters. Next, since most students in the course will probably work for a business fi rm, we wanted to show them how the core ideas are implemented in practice. Therefore, in the remainder of the book we discuss cost of capital, capital budgeting, capital structure, dividend policy, working capital management, fi nancial forecasting, and international operations.



iv Preface

Nonfi nance majors sometimes wonder why they need to learn about fi nance. As we structured the book, it should be obvious to everyone why they need to understand time value, risk, markets, and valuation. Virtually all students enrolled in the basic course expect at some point to have some money to invest, and they quickly realize that the knowledge gained from Chapters 1 through 9 will help them make better investment decisions. Moreover, students who plan to go into business soon realize that their own success requires that their fi rms be successful, and the topics covered in Chapters 10 through 17 will be helpful here. For exam- ple, good capital budgeting decisions require accurate forecasts from people in sales, marketing, production, and human resources, and those people need to understand how their actions affect the fi rm’s profi ts and future.

ORGANIZATION OF THE CHAPTERS: A VALUATION FOCUS As we discuss in Chapter 1, in an enterprise system such as that of the United States, the primary goal of fi nancial management is to help managers maximize their fi rms’ values, subject to constraints such as not polluting the environment, not engaging in unfair labor practices, not engaging in antitrust activities, and the like. Therefore, valuation underlies everything in Concise. In Chapter 1 we discuss the concept of valuation, explain how it depends on future cash fl ows and risk, and show why value maximization is good for society in general. The valuation theme runs throughout the text.

Values are not established in a vacuum—stock and bond values are deter- mined in the fi nancial markets, so an understanding of those markets is essential to anyone involved with fi nance. Therefore, Chapter 2 covers the major types of fi nancial markets, the returns that investors have historically earned, and the risks inherent in different types of securities. This information is important for anyone working in fi nance, and it is also important for anyone who has or hopes to own any fi nancial assets.

Asset values depend in a fundamental way on earnings and cash fl ows as reported in the accounting statements. Therefore, we review those statements in Chapter 3 and then, in Chapter 4, show how accounting data can be analyzed and used to measure how well a company has operated in the past and how it is likely to perform in the future.

Chapter 5 covers the Time Value of Money (TVM), perhaps the most funda- mental concept in fi nance. The basic valuation model, which ties together cash fl ows, risk, and interest rates, is based on TVM concepts, and these concepts are used throughout the remainder of the book. Therefore, students should be sure to allocate plenty of time to Chapter 5.

Chapter 6 deals with interest rates, a key determinant of asset values. We dis- cuss how interest rates are affected by risk, infl ation, liquidity, the supply of and demand for capital in the economy, and the actions of the Federal Reserve.

The discussion of interest rates leads directly to bonds in Chapter 7 and stocks in Chapters 8 and 9. We show how both stocks and bonds (and all other fi nancial assets) are valued using the basic TVM model.

Chapters 1 through 9 provide background information that is essential to both investors and corporate managers. These are “Finance” topics, not “Business” or “Corporate Finance” topics as those terms are commonly used. Thus, Chapters 1 through 9 discuss the concepts and models used to establish values, whereas Chapters 10 through 17 focus on specifi c actions managers can take to maximize their fi rms’ values.

As we noted above, most business students don’t plan to specialize in fi nance, so they might not think the “business fi nance” chapters are particularly relevant to




them. This is not true, and in the later chapters we show that all really important business decisions involve all of the fi rm’s departments—marketing, accounting, production, and so on. Thus, while capital budgeting can be thought of as a fi nan- cial decision, marketing people provide inputs on likely unit sales and sales prices, manufacturing people provide inputs on costs, and so on. Moreover, capital bud- geting decisions infl uence the size of the fi rm, its products, and its profi ts, and those factors affect all the fi rm’s employees, from the CEO to the mail room staff.

STRUCTURAL CHANGES We made two important structural changes in this new edition: 1. We moved the material on fi nancial markets and institutions from Chapter 5 to

Chapter 2. Markets and institutions follow naturally from Chapter 1, and this material provides useful background information for the remainder of the book.

2. We moved the time value of money (TVM) chapter from Chapter 2 to Chapter 5. Under the previous structure, we covered TVM concepts, then covered the accounting and fi nancial markets chapters before applying TVM concepts to bond and stock valuation. We liked the idea of covering TVM early, but we con- cluded that it was pedagogically better to cover TVM concepts and then imme- diately focus on applications, as we do now.

These changes improve the fl ow of the text signifi cantly—there is a much smoother transition from chapter to chapter in the fi rst part of the book.

OTHER CHANGES We made many other changes, but the following are the most signifi cant: 1. Editing. We always edit each new edition to improve clarity, but we did more

in this edition than ever before. We put the entire text on digital fi les, which facilitated shifting things around to improve transitions and fl ow. Students will fi nd it easier to read the book than in the past.

2. Beginning-of-Chapter Vignettes and Within-Chapter Boxes. Many events have transpired in the fi nancial markets during the past three years. Credit markets have tightened almost to the point of collapse; the housing and auto markets are in terrible shape; a major investment bank (Bear Stearns) failed; the heads of a number of major corporations were fi red; and so on. We use these events as the subjects of many vignettes and boxes, and they illus- trate the points made in the chapters very well.

3. Learning Objectives. To help students see what we expect them to take away from the chapters, we added a set of learning objectives at the beginning of each chapter.

4. Excel. Spreadsheets, especially Excel, are becoming increasingly important in business, and students who are familiar with Excel have a signifi cant advan- tage in the job market and later on the job. We used Excel in two ways. First, we worked all the in-text examples, end-of-chapter problems, and test bank problems with both Excel and a calculator, using the calculator to make sure the problem is workable with a calculator and Excel to check for accuracy. Sec- ond, we used Excel to create many of the tables and graphs used in the text, we displayed them as Excel pictures, and we have made available the models we used. Students do not need to know how to use Excel to go through the book, but if they are somewhat familiar with it, they can see how many common



vi Preface

fi nancial problems can be set up and solved very effi ciently with Excel. Stu- dents who are not familiar with Excel should also be motivated to learn some- thing about it.

5. Tie-In between Self-Test Questions, End-of-Chapter Questions, and the Test Bank. Testing is obviously important, so we spent a lot of time improving the Test Bank. Every question and problem was reviewed for clar- ity, accuracy, and consistency with the text. Also, we set up self-test questions at the end of each major section within the text to enable students to take real- time tests on their own before moving on. Then, the end-of-chapter (EOC) questions and problems are similar to, but often go beyond, the self-test ques- tions, and the test bank questions and problems are similar to the EOC materi- als. If students read the text, do the self-test questions as they go along, and then work a sampling of the EOC questions and problems, they should do well on exams drawn from the test bank.

6. Accounting Statements and Free Cash Flow. Most students in the basic fi nance course are familiar with balance sheets and income statements, but many don’t really understand the statement of cash fl ows and its relationship to free cash fl ows. Reviewers told us that in the last edition we tried to do too many things—like present alternative ways to calculate free cash fl ow—and that we should delete some of these items and better explain what remained. We agreed, and this edition does a much better job in this regard.

7. Cash Flows and Risk in Capital Budgeting. In the last edition, the two chapters on capital budgeting (Chapters 11 and 12) were not tied together very well. In that edition, we used relatively simple and straightforward illustrative projects in Chapter 11 but switched to entirely different and much more com- plex projects in Chapter 12. For this edition, we rewrote Chapter 12, continu- ing with the Chapter 11 examples. We also re-ordered materials to present them in a more logical sequence. One reviewer stated that this chapter was the single biggest improvement in the 6th edition.

8. Financial Forecasting. As we were rewriting Chapter 16, GE’s chairman announced that he expected to report higher earnings shortly, but two weeks later he announced a signifi cant earnings decline, and that led to a sharp drop in GE’s stock price. We used this example to illustrate the importance of accu- rate forecasts and to liven up our discussion of strategic fi nancial planning. In addition, we used an improved Excel model to streamline our illustrative fore- cast and to make the forecasting process simpler and clearer to students.

We could continue to list changes in this edition, but the items we have just discussed provide instructors (particularly those familiar with the last edition) with a good idea of what revisions were made to this text, and it will also let students know how authors try to continually improve their texts.

ACKNOWLEDGMENTS The book refl ects the efforts of a great many people, both those who have worked on Concise and our related books in the past and those who worked specifi cally on this Sixth Edition. First, we would like to thank Dana Aberwald Clark, who worked closely with us at every stage of the revision—her assistance was absolutely invalu- able. Second, Susan Whitman provided great typing and logistical support.

Our colleagues Roy Crum, Jim Keys, Andy Naranjo, M. Nimalendran, Jay Ritter, Mike Ryngaert, Craig Tapley, and Carolyn Takeda Brown gave us many useful suggestions regarding the ancillaries and many parts of the book, including the integrated cases. We also benefi ted from the work of Mike Ehrhardt and Phillip




Daves of the University of Tennessee, and Roy Crum of the University of Florida, who worked with us on companion books. Also, Christopher Buzzard did an out- standing job helping us develop the Excel models, the web site, and the PowerPoint presentations.

Next, we would like to thank the following professors, who reviewed this edi- tion in detail and provided many useful comments and suggestions:

Rebecca Abraham—Nova Southeastern University Kavous Ardalan—Marist College Tom Arnold—University of Richmond Deborah Bauer—University of Oregon Gary Benesh—Florida State University Mark S. Bettner—Bucknell University Brian Boscaljon—Penn State University: Erie Elizabeth Booth—Michigan State University Rajesh Chakrabarti—Georgia Institute of Technology Brent Dalrymple—University of Central Florida Jim DeMello—Western Michigan University Anne M. Drougas—Dominican University Scott Ehrhorn—Liberty University David Feller—Brevard Community College Jennifer Foo—Stetson University Partha Gangopadhyay—St. Cloud State University Sharon H. Garrison—University of Arizona Robert P. Hoffman—College of St. Scholastica Benjamas Jirasakuldech—University of the Pacifi c Ashok Kapoor—Augsburg College Howard Keen—Temple University Christopher J. Lambert, J.D.—Fairmont State University Alice Lee—San Francisco State University Denise Letterman—Robert Morris University Yulong Ma—California State University—Long Beach Barry Marchman—Florida A&M Brian Maris—Northern Arizona University Matthew Morey—Pace University Tom C. Nelson—Leeds School of Business, Colorado University—Boulder Darshana Palkar—Minnesota State University, Mankato Narendar V. Rao—Northeastern Illinois University Charles R. Rayhorn—Northern Michigan University Oliver Schnusenberg—University of North Florida Dean S. Sommers—University of Delaware Michael Spivey—Clemson University Glenn L. Stevens—Franklin & Marshall College Lowell E. Stockstill—Wittenberg University Samantha Thapa—Western Kentucky University David O. Vang—University of St. Thomas Sheng Yang—Black Hills State University David Zalewski—Providence College Sijing Zong—California State University—Stanislaus



viii Preface

We would also like to thank the following professors, whose reviews and com- ments on our earlier books contributed to this edition:

Robert Adams Mike Adler Sharif Ahkam Syed Ahmad Ed Altman Bruce Anderson Ron Anderson Tom Anderson John Andrews Bob Angell Vince Apilado Harvey Arbalaez Henry Arnold Bob Aubey Gil Babcock Peter Bacon Kent Baker Robert Balik Tom Bankston Babu Baradwaj Les Barenbaum Charles Barngrover Sam Basu Greg Bauer Bill Beedles Brian Belt Moshe Ben-Horim Bill Beranek Tom Berry Will Bertin Scott Besley Dan Best Roger Bey Gilbert W. Bickum Dalton Bigbee John Bildersee Laurence E. Blose Russ Boisjoly Bob Boldin Keith Boles Michael Bond Geof Booth Waldo Born Steven Bouchard Rick Boulware

Kenneth Boudreaux

Helen Bowers Oswald Bowlin Don Boyd G. Michael Boyd Pat Boyer Joe Brandt Elizabeth

Brannigan Mary Broske David T. Brown Christopher Brown Kate Brown Larry Brown Bill Brueggeman Paul Bursik Alva Butcher Bill Campsey Bob Carlson Severin Carlson David Cary Steve Celec Mary Chaffi n Charles Chan Don Chance Antony Chang Susan Chaplinsky K. C. Chen Jay Choi S. K. Choudhary Lal Chugh Maclyn Clouse Bruce Collins Mitch Conover Margaret

Considine Phil Cooley Joe Copeland David Cordell Marsha Cornett M. P. Corrigan John Cotner Charles Cox David Crary

John Crockett, Jr. Bill Damon Morris Danielson Joel Dauten Steve Dawson Sankar De Fred Dellva Chad Denson James Desreumaux Bodie Dickerson Bernard Dill Gregg Dimkoff Les Dlabay Mark Dorfman Tom Downs Frank Draper Gene Drzycimski Dean Dudley David Durst Ed Dyl Fred J. Ebeid Daniel Ebels Richard Edelman Charles Edwards U. Elike John Ellis George Engler Suzanne Erickson Dave Ewert John Ezzell L. Franklin Fant Richard J. Fendler Michael Ferri Jim Filkins John Finnerty Robert Fiore Susan Fischer Peggy Fletcher Steven Flint Russ Fogler Jennifer Frazier Dan French Michael Garlington David Garraty Jim Garven

Adam Gehr, Jr. Jim Gentry Wafi ca Ghoul Erasmo Giambona Armand

Gilinsky, Jr. Philip Glasgo Rudyard Goode Raymond Gorman Walt Goulet Bernie Grablowsky Theoharry

Grammatikos Owen Gregory Ed Grossnickle John Groth Alan Grunewald Manak Gupta Darryl Gurley Sam Hadaway Don Hakala Gerald Hamsmith William Hardin John Harris Paul Hastings Bob Haugen Steve Hawke Stevenson Hawkey Del Hawley Eric M. Haye Robert Hehre Kath Henebry David Heskel George

Hettenhouse Hans Heymann Kendall Hill Roger Hill Tom Hindelang Linda Hittle Ralph Hocking J. Ronald

Hoffmeister Robert Hollinger Jim Horrigan




John Houston John Howe Keith Howe Steve Isberg Jim Jackson Keith Jakob Vahan Janjigian Narayanan

Jayaraman Zhenhn Jin Kose John Craig Johnson Keith Johnson Ramon Johnson Steve Johnson Ray Jones Frank Jordan Manuel Jose Sally Joyner Alfred Kahl Gus Kalogeras Rajiv Kalra Ravi Kamath John Kaminarides Michael Keenan Bill Kennedy Peppi M. Kenny Carol Kiefer Joe Kiernan Richard Kish Robert Kleiman Erich Knehans Don Knight Ladd Kochman Dorothy Koehl Jaroslaw

Komarynsky Duncan Kretovich Harold Krogh Charles Kroncke Don Kummer Robert A. Kunkel Reinhold Lamb Joan Lamm Larry Lang David Lange P. Lange Howard Lanser

Edward Lawrence Martin Lawrence Wayne Lee Jim LePage David E.

LeTourneau Jules Levine John Lewis Jason Lin Chuck Linke Bill Lloyd Susan Long Judy Maese Bob Magee Ileen Malitz Bob Malko Phil Malone Abbas

Mamoozadeh Terry Maness Chris Manning Surendra

Mansinghka Timothy Manuel Terry Martell David Martin D. J. Masson John Mathys Ralph May John McAlhany Andy McCollough Ambrose McCoy Thomas McCue Bill McDaniel John McDowell Charles McKinney Robyn McLaughlin James McNulty Jeanette Medewitz-

Diamond Jamshid Mehran Larry Merville Rick Meyer Jim Millar Ed Miller John Miller John Mitchell Carol Moerdyk

Bob Moore Scott Moore Barry Morris Gene Morris Dianne R.

Morrison Chris Muscarella David Nachman Tim Nantell Don Nast Edward Nelling Bill Nelson Bob Nelson William Nelson Bob Niendorf Bruce Niendorf Ben Nonnally, Jr. Tom O’Brien William O’Connell Dennis O’Connor John O’Donnell Jim Olsen Robert Olsen Dean Olson Jim Pappas Stephen Parrish Helen Pawlowski Barron Peake Michael Pescow Glenn Petry Jim Pettijohn Rich Pettit Dick Pettway Aaron Phillips Hugo Phillips H. R. Pickett John Pinkerton Gerald Pogue Eugene Poindexter R. Potter Franklin Potts R. Powell Dianna Preece Chris Prestopino John Primus Jerry Prock Howard Puckett Herbert Quigley

George Racette Bob Radcliffe David Rakowski Allen Rappaport Bill Rentz Ken Riener Charles Rini John Ritchie Bill Rives Pietra Rivoli Antonio

Rodriguez James Rosenfeld Stuart Rosenstein E. N. Roussakis Dexter Rowell Arlyn R. Rubash Marjorie Rubash Bob Ryan Jim Sachlis Abdul Sadik Travis Sapp Thomas Scampini Kevin Scanlon Frederick

Schadeler Patricia L. Schaeff David Schalow Mary Jane Scheuer David Schirm Robert Schwebach Carol Schweser John Settle Alan Severn James Sfi ridis Sol Shalit Frederic Shipley Dilip Shome Ron Shrieves Neil Sicherman J. B. Silvers Clay Singleton Joe Sinkey Stacy Sirmans Jaye Smith Patricia Smith Patricia Matisz




x Preface

Special thanks are due to Chris Barry, Texas Christian University, and Shirley Love, Idaho State University, who wrote many of the boxes relating to small- business issues that are on the Web; to Emery Trahan and Paul Bolster, North- eastern University, who developed and wrote the summaries and questions for NewsWire; to Dilip Shome, Virginia Polytechnic Institute, who helped greatly with the capital structure chapter; to Dave Brown and Mike Ryngaert, University of Florida, who helped us with the bankruptcy and merger material; to Roy Crum, Andy Naranjo, and Subu Venkataraman, who worked with us on the international materials; to Scott Below, East Carolina University, who developed the Web site information and references; to Laurie and Stan Eakins of East Caro- lina, who developed the materials on Excel for the Technology Supplement; and to Larry Wolken, Texas A&M University, who offered his hard work and advice for the development of the Lecture Presentation Software. Finally, the South-Western and LEAP Publishing staffs, especially Mike Guendelsberger, Malvine Litten, Jennifer Ziegler, Scott Fidler, Mike Reynolds, Mike Roche, Adele Scholtz, Suellen Ruttkay, and Alex Von Rosenberg, helped greatly with all phases of the text- book’s development and production.

ERRORS IN THE TEXTBOOK At this point, most authors make a statement 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 generally there are more than enough remaining errors! Having experienced diffi culties with errors ourselves, both as students and instructors, we resolved to avoid this problem in Concise. As a result of our detec- tion procedures, we are convinced that few such errors remain, but primarily because we want to detect any errors that may have slipped by so that we can cor- rect them in subsequent printings, we decided to offer a reward of $10 per error to the fi rst person who reports it to us. For purpose of this reward, errors are defi ned as misspelled words, nonrounding numerical errors, incorrect statements, and any other error that inhibits comprehension. Typesetting problems such as irregular

Don Sorensen David Speairs Ken Stanley Kenneth Stanton Ed Stendardi Alan Stephens Don Stevens Jerry Stevens Glen Strasburg David Suk Katherine Sullivan Timothy Sullivan Philip Swensen Bruce Swenson Ernest Swift Paul Swink Eugene Swinnerton Gary Tallman

Dular Talukdar Dennis Tanner Russ Taussig John Teall Richard Teweles Ted Teweles Madeline Thimmes Francis D. Thomas Andrew Thompson John Thompson Arlene Thurman Dogan Tirtirogu Janet Todd Holland J. Toles William Tozer Emery Trahan George Trivoli George Tsetsekos

David Upton Howard Van

Auken Pretorious Van

den Dool Pieter Vandenberg Paul Vanderheiden JoAnn Vaughan Jim Verbrugge Patrick Vincent Steve Vinson Susan Visscher John Wachowicz Joe Walker Mike Walker Sam Weaver Marsha Weber Al Webster

Shelton Weeks Kuo-Chiang Wei Bill Welch Fred Weston Richard Whiston Norm Williams Tony Wingler Ed Wolfe Criss Woodruff Don Woods Yangru Wu Robert Wyatt Steve Wyatt Michael Yonan John Zietlow Dennis Zocco Kent Zumwalt




spacing and differences of opinion regarding grammatical or punctuation conven- tions do not qualify for this reward. Given the ever-changing nature of the World Wide Web, changes in web addresses also do not qualify as errors, although we would like to learn about them. Finally, any qualifying error that has follow- through effects is counted as two errors only. Please report any errors to Joel Hous- ton either through e-mail at or by regular mail at the address below.

CONCLUSION Finance is, in a real sense, the cornerstone of the enterprise system—good fi nancial management is vitally important to the economic health of all fi rms, hence to the nation and the world. Because of its importance, fi nance should be widely and thoroughly understood, but this is easier said than done. The fi eld is complex, and it undergoes constant change due to shifts in economic conditions. All of this makes fi nance stimulating and exciting, but challenging and sometimes perplex- ing. We sincerely hope that this Sixth Edition of Concise will meet its own challenge by contributing to a better understanding of our fi nancial system.

EUGENE F. BRIGHAM JOEL F. HOUSTON 4723 N.W. 53rd Ave., Suite A Gainesville, Florida 32653

July 2008





Preface iii

PART 1 Introduction to Financial Management 1 CHAPTER 1 An Overview of Financial Management 2

PART 2 Fundamental Concepts in Financial Management 25 CHAPTER 2 Financial Markets and Institutions 26 CHAPTER 3 Financial Statements, Cash Flow, and Taxes 54 CHAPTER 4 Analysis of Financial Statements 85 CHAPTER 5 Time Value of Money 123

PART 3 Financial Assets 161 CHAPTER 6 Interest Rates 162 CHAPTER 7 Bonds and Their Valuation 194 CHAPTER 8 Risk and Rates of Return 229 CHAPTER 9 Stocks and Their Valuation 269

PART 4 Investing in Long-Term Assets: Capital Budgeting 305 CHAPTER 10 The Cost of Capital 306 CHAPTER 11 The Basics of Capital Budgeting 335 CHAPTER 12 Cash Flow Estimation and Risk Analysis 364

PART 5 Capital Structure and Dividend Policy 399 CHAPTER 13 Capital Structure and Leverage 400 CHAPTER 14 Distributions to Shareholders: Dividends and Share Repurchases 440

PART 6 Working Capital Management, Forecasting, and Multinational Financial Management 471

CHAPTER 15 Working Capital Management 472 CHAPTER 16 Financial Planning and Forecasting 509 CHAPTER 17 Multinational Financial Management 534

Appendixes APPENDIX A Solutions to Self-Test Questions and Problems A-1 APPENDIX B Answers to Selected End-of-Chapter Problems A-24 APPENDIX C Selected Equations and Tables A-27

Index I-1





PART 1 Introduction to Financial Management 1

CHAPTER 1 An Overview of Financial Management 2 Striking the Right Balance 2


1-1 What Is Finance 4 Finance Versus Economics and Accounting 4 Finance within an Organization 4 Corporate Finance, Capital Markets, and Investments 5

1-2 Jobs in Finance 6

1-3 Forms of Business Organization 6

1-4 Stock Prices and Shareholder Value 8

1-5 Intrinsic Values, Stock Prices, and Executive Compensation 10

1-6 Important Business Trends 14 Global Perspectives: Is Shareholder Wealth Maximization a Worldwide Goal? 14

1-7 Business Ethics 15 What Companies Are Doing 15 Consequences of Unethical Behavior 16 How Should Employees Deal with Unethical Behavior? 17 Protection for Whistle-Blowers 17

1-8 Conflicts Between Managers, Stockholders, and Bondholders 18 Managers versus Stockholders 18 Stockholders versus Bondholders 20


PART 2 Fundamental Concepts in Financial Management 25

CHAPTER 2 Financial Markets and Institutions 26 Efficient Financial Markets Are Necessary for a Growing Economy 26


2-1 The Capital Allocation Process 28

2-2 Financial Markets 30 Types of Markets 30 Recent Trends 31

2-3 Financial Institutions 34 Citigroup Built to Compete in a Changing Environment 37

2-4 The Stock Market 38 Global Perspectives: The NYSE and Nasdaq Go Global 38 Physical Location Stock Exchanges 39 Over-the-Counter (OTC) and the Nasdaq Stock Markets 39

2-5 The Market for Common Stock 40 Types of Stock Market Transactions 41

2-6 Stock Markets and Returns 43 Stock Market Reporting 43 Measuring the Market 45 Stock Market Returns 46

2-7 Stock Market Efficiency 46 A Closer Look at Behavioral Finance Theory 49 Conclusions about Market Efficiency 50


INTEGRATED CASE Smyth Barry & Company 52

CHAPTER 3 Financial Statements, Cash Flow, and Taxes 54 The “Quality” of Financial Statements 54


3-1 Financial Statements and Reports 55

3-2 The Balance Sheet 57 Allied’s Balance Sheet 58

3-3 The Income Statement 61

3-4 Statement of Cash Flows 63 Massaging the Cash Flow Statement 66

3-5 Statement of Stockholders’ Equity 67 Financial Analysis on the Internet 68





3-6 Free Cash Flow 68 Free Cash Flow Is Important for Small Businesses 69

3-7 Income Taxes 70 Individual Taxes 70 Corporate Taxes 72


INTEGRATED CASE D’Leon Inc., Part I 81 THOMSON ONE: BUSINESS SCHOOL EDITION Exploring Starbucks’ Financial Statements 84

CHAPTER 4 Analysis of Financial Statements 85 Can You Make Money Analyzing Stocks? 85


4-1 Ratio Analysis 87

4-2 Liquidity Ratios 88 Current Ratio 88 Quick, or Acid Test, Ratio 89

4-3 Asset Management Ratios 89 Inventory Turnover Ratio 90 Days Sales Outstanding 90 Fixed Assets Turnover Ratio 91 Total Assets Turnover Ratio 92

4-4 Debt Management Ratios 92 Total Debt to Total Assets 94 Times-Interest-Earned Ratio 95

4-5 Profitability Ratios 96 Operating Margin 96 Profit Margin 96 Global Perspectives: Global Accounting Standards: Can One Size Fit All? 97 Return on Total Assets 97 Basic Earning Power (BEP) Ratio 98 Return on Common Equity 98

4-6 Market Value Ratios 99 Price/Earnings Ratio 99 Market/Book Ratio 99

4-7 Trend Analysis 100

4-8 The DuPont Equation 101

4-9 Ratios in Different Industries 103

4-10 Summary of Allied’s Ratios 104

4-11 Benchmarking 105 Looking for Warning Signs within the Financial Statements 106

4-12 Uses and Limitations of Ratios 106 Economic Value Added (EVA) versus Net Income 108

4-13 Potential Misuses of ROE 108

4-14 Looking Beyond the Numbers 109


INTEGRATED CASE D’Leon Inc., Part II 118 THOMSON ONE: BUSINESS SCHOOL EDITION Conducting a Financial Ratio Analysis on Ford Motor Company 122

CHAPTER 5 Time Value of Money 123 Will You Be Able to Retire? 123


5-1 Time Lines 124

5-2 Future Values 125 Step-by-Step Approach 126 Simple versus Compound Interest 126 Formula Approach 127 Financial Calculators 127 Spreadsheets 128 Graphic View of the Compounding Process 130

5-3 Present Values 131 Graphic View of the Discounting Process 132

5-4 Finding the Interest Rate, I 133

5-5 Finding the Number of Years, N 134

5-6 Annuities 134

5-7 Future Value of an Ordinary Annuity 135

5-8 Future Value of an Annuity Due 137

5-9 Present Value of an Ordinary Annuity 138

5-10 Finding Annuity Payments, Periods, and Interest Rates 139 Finding Annuity Payments, PMT 139 Finding the Number of Periods, N 139 Finding the Interest Rate, I 140

5-11 Perpetuities 141

5-12 Uneven Cash Flows 143

5-13 Future Value of an Uneven Cash Flow Stream 144

5-14 Solving for I with Uneven Cash Flows 145

5-15 Semiannual and Other Compounding Periods 146

5-16 Comparing Interest Rates 148

5-17 Fractional Time Periods 150

5-18 Amortized Loans 151






INTEGRATED CASE First National Bank 159 WEB APPENDIX 5A Continuous Compounding and Discounting

WEB APPENDIX 5B Growing Annuities

PART 3 Financial Assets 161

CHAPTER 6 Interest Rates 162 Low Interest Rates Encourage Investment and Stimulate Consumer Spending 162


6-1 The Cost of Money 163

6-2 Interest Rate Levels 165

6-3 The Determinants of Market Interest Rates 168 The Real Risk-Free Rate of Interest, r* 169 The Nominal, or Quoted, Risk-Free Rate of Interest, rRF ! r* ” IP 170 Inflation Premium (IP) 170 An Almost Riskless Treasury Bond 171 Default Risk Premium (DRP) 172 Liquidity Premium (LP) 172 A 20% Liquidity Premium on a High-Grade Bond 173 Interest Rate Risk and the Maturity Risk Premium (MRP) 173

6-4 The Term Structure of Interest Rates 175

6-5 What Determines the Shape of the Yield Curve? 176 The Links between Expected Inflation and Interest Rates: A Closer Look 178

6-6 Using the Yield Curve to Estimate Future Interest Rates 180

6-7 Macroeconomic Factors That Influence Interest Rate Levels 183 Federal Reserve Policy 183 Federal Budget Deficits or Surpluses 184 International Factors 184 Business Activity 185

6-8 Interest Rates and Business Decisions 185


INTEGRATED CASE Morton Handley & Company 192

CHAPTER 7 Bonds and Their Valuation 194 Sizing Up Risk in the Bond Market 194


7-1 Who Issues Bonds? 195

7-2 Key Characteristics of Bonds 196 Par Value 197 Coupon Interest Rate 197 Maturity Date 197 Call Provisions 198 Sinking Funds 199 Other Features 199

7-3 Bond Valuation 200

7-4 Bond Yields 203 Yield to Maturity 203 Yield to Call 204

7-5 Changes in Bond Values Over Time 206

7-6 Bonds with Semiannual Coupons 209

7-7 Assessing a Bond’s Riskiness 210 Interest Rate Risk 210 Reinvestment Rate Risk 213 Comparing Interest Rate and Reinvestment Rate Risk 213

7-8 Default Risk 214 Various Types of Corporate Bonds 215 Bond Ratings 215 Bankruptcy and Reorganization 219

7-9 Bond Markets 220


INTEGRATED CASE Western Money Management Inc. 228 WEB APPENDIX 7A Zero Coupon Bonds

WEB APPENDIX 7B Bankruptcy and Reorganization

CHAPTER 8 Risk and Rates of Return 229 A Tale of Three Markets—or Is It Four? 229


8-1 Stock Prices Over the Last 20 Years 231

8-2 Stand-Alone Risk 232 Statistical Measures of Stand-Alone Risk 233 Measuring Stand-Alone Risk: The Standard Deviation 236 Using Historical Data to Measure Risk 237





Measuring Stand-Alone Risk: The Coefficient of Variation 238 Risk Aversion and Required Returns 238 The Trade-Off between Risk and Return 239

8-3 Risk in a Portfolio Context: The CAPM 240 Expected Portfolio Returns, r̂p 241 Portfolio Risk 242 Risk in a Portfolio Context: The Beta Coefficient 245 Global Perspectives: The Benefits of Diversifying Overseas 250

8-4 The Relationship between Risk and Rates of Return 251 Estimating the Market Risk Premium 252 The Impact of Expected Inflation 253 Changes in Risk Aversion 255 Changes in a Stock’s Beta Coefficient 256

8-5 Some Concerns about Beta and the CAPM 257

8-6 Some Concluding Thoughts: Implications for Corporate Managers and Investors 258


INTEGRATED CASE Merrill Finch Inc. 266 THOMSON ONE: BUSINESS SCHOOL EDITION Using Past Information to Estimate Required Returns 268

WEB APPENDIX 8A Calculating Beta Coefficients

CHAPTER 9 Stocks and Their Valuation 269 Searching for the Right Stock 269


9-1 Legal Rights and Privileges of Common Stockholders 270 Control of the Firm 271 The Preemptive Right 272

9-2 Types of Common Stock 272

9-3 Stock Price versus Intrinsic Value 273 Why Do Investors and Companies Care About Intrinsic Value? 274

9-4 The Discounted Dividend Model 275 Expected Dividends as the Basis for Stock Values 277

9-5 Constant Growth Stocks 278 Illustration of a Constant Growth Stock 279

Dividends versus Growth 280 Which Is Better: Current Dividends or Growth? 282 Required Conditions for the Constant Growth Model 282

9-6 Valuing Nonconstant Growth Stocks 283

9-7 Valuing the Entire Corporation 286 Evaluating Stocks That Don’t Pay Dividends 287 The Corporate Valuation Model 288 Other Approaches to Valuing Common Stocks 290 Comparing the Corporate Valuation and Discounted Dividend Models 290

9-8 Preferred Stock 291


INTEGRATED CASE Mutual of Chicago Insurance Company 298 THOMSON ONE: BUSINESS SCHOOL EDITION Estimating ExxonMobil’s Intrinsic Stock Value 299

APPENDIX 9A Stock Market Equilibrium 301

PART 4 Investing in Long-Term Assets: Capital Budgeting 305

CHAPTER 10 The Cost of Capital 306 Creating Value at GE 306


10-1 An Overview of the Weighted Average Cost of Capital (WACC) 307

10-2 Basic Definitions 309

10-3 Cost of Debt, rd(1 – T) 310

10-4 Cost of Preferred Stock, rp 312

10-5 The Cost of Retained Earnings, rs 312 The CAPM Approach 314 Bond-Yield-plus-Risk-Premium Approach 315 Dividend-Yield-plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach 315 Averaging the Alternative Estimates 317

10-6 Cost of New Common Stock, re 318 Add Flotation Costs to a Project’s Cost 318 Increase the Cost of Capital 318





How Much Does It Cost to Raise External Capital? 319 When Must External Equity Be Used? 320

10-7 Composite, or Weighted Average, Cost of Capital, WACC 321

10-8 Factors That Affect the WACC 321 Factors the Firm Cannot Control 321 Factors the Firm Can Control 322 Global Perspectives: Global Variations in the Cost of Capital 322

10-9 Adjusting the Cost of Capital for Risk 323

10-10 Some Other Problems with Cost of Capital Estimates 325


INTEGRATED CASE Coleman Technologies Inc. 333 THOMSON ONE: BUSINESS SCHOOL EDITION Calculating 3M’s Cost of Capital 334

WEB APPENDIX 10A The Cost of New Common Stock and WACC

CHAPTER 11 The Basics of Capital Budgeting 335 Competition in the Aircraft Industry: Airbus vs. Boeing 335


11-1 An Overview of Capital Budgeting 336

11-2 Net Present Value (NPV) 338

11-3 Internal Rate of Return (IRR) 341 Why NPV Is Better Than IRR 343

11-4 Multiple Internal Rates of Return 344

11-5 Reinvestment Rate Assumptions 346

11-6 Modified Internal Rate of Return (MIRR) 347

11-7 NPV Profiles 349

11-8 Payback Period 353

11-9 Conclusions on Capital Budgeting Methods 355

11-10 Decision Criteria Used in Practice 356


INTEGRATED CASE Allied Components Company 362

CHAPTER 12 Cash Flow Estimation and Risk Analysis 364 Home Depot Keeps Growing 364


12-1 Conceptual Issues in Cash Flow Estimation 365 Cash Flow versus Accounting Income 365 Timing of Cash Flows 366 Incremental Cash Flows 366 Replacement Projects 366 Sunk Costs 366 Opportunity Costs Associated with Assets the Firm Owns 367 Externalities 367

12-2 Analysis of an Expansion Project 369 Effect of Different Depreciation Rates 371 Cannibalization 371 Opportunity Costs 371 Sunk Costs 371 Other Changes to the Inputs 372

12-3 Replacement Analysis 372

12-4 Risk Analysis in Capital Budgeting 374

12-5 Measuring Stand-Alone Risk 376 Sensitivity Analysis 376 Scenario Analysis 378 Monte Carlo Simulation 379 Global Perspectives: Capital Budgeting Practices in the Asian/Pacific Region 380

12-6 Within-Firm and Beta Risk 381

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