F U N D AM E N TA L S OF FINANCIAL M A N A GE M E N T Concise Sixth Edition Eugene F Brigham U NIV E RS IT Y O F F L O RID A Joel F Houston U NIV E RS IT Y O F F L O RID A Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States Fundamentals of Financial Management: Concise Edition, 6th edition Eugene F Brigham, Joel F Houston Vice President of Editorial, Business: Jack W Calhoun Editor-in-Chief: Alex von Rosenberg Executive Editor: Michael R Reynolds Development Editor: Michael Guendelsberger Senior Marketing Manager: Brian Joyner Marketing Coordinator: Suellen Ruttkay Senior Marketing Communications Manager: Jim Overly Web site Project Manager: Brian Courter Frontlist Buyer, Manufacturing: Kevin Kluck Senior Art Director: Michelle Kunkler Content Project Manager: Jennifer A Ziegler © 2009, 2007 South-Western, a part of Cengage Learning ALL RIGHTS RESERVED No part of this work covered by the copyright hereon may be reproduced or used in any form 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Manager: Sheri Blaney South-Western Cengage Learning 5191 Natorp Boulevard Mason, OH 45040 USA Cengage Learning products are represented in Canada by Nelson Education, Ltd For your course and learning solutions, visit academic.cengage.com Purchase any of our products at your local college store or at our preferred online store www.ichapters.com Printed in the United States of America 12 11 10 09 08 PRE FAC E The first edition of Fundamentals was published 30 years ago Since then, the body of financial 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 difficult 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 flexibility 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 difficult 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 first created Concise, we debated between streamlining the book by covering all the topics but in less depth versus covering fewer topics but maintaining 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 interesting and important, they are not critically important, and finance majors will study these topics later in their advanced courses STRUCTURE OF THE BOOK Our target audience is undergraduate students taking their first, and often only, finance course Some will decide to major in finance and go on to take courses in investments, money and capital markets, and advanced corporate finance Others will choose marketing, management, or some other nonfinance major Still others will major in areas other than business and are taking finance and a few other business courses to gain information that will help them in law, real estate, or other fields 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 finance, i.e., on basic topics such as the time value of money, risk analysis, and valuation Moreover, 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 business manager trying to maximize the value of his or her firm’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 after they finish the course In setting up the structure of the book, we first listed the core topics in finance with which virtually everyone should be familiar Included here are an overview of financial markets, methods used to estimate the cash flows 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 first nine chapters Next, since most students in the course will probably work for a business firm, 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, financial forecasting, and international operations iii iv Preface Nonfinance majors sometimes wonder why they need to learn about finance 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 through will help them make better investment decisions Moreover, students who plan to go into business soon realize that their own success requires that their firms be successful, and the topics covered in Chapters 10 through 17 will be helpful here For example, 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 firm’s profits 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 financial management is to help managers maximize their firms’ 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 we discuss the concept of valuation, explain how it depends on future cash flows 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 determined in the financial markets, so an understanding of those markets is essential to anyone involved with finance Therefore, Chapter covers the major types of financial 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 finance, and it is also important for anyone who has or hopes to own any financial assets Asset values depend in a fundamental way on earnings and cash flows as reported in the accounting statements Therefore, we review those statements in Chapter 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 covers the Time Value of Money (TVM), perhaps the most fundamental concept in finance The basic valuation model, which ties together cash flows, 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 Chapter deals with interest rates, a key determinant of asset values We discuss how interest rates are affected by risk, inflation, 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 and stocks in Chapters and We show how both stocks and bonds (and all other financial assets) are valued using the basic TVM model Chapters through 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 through discuss the concepts and models used to establish values, whereas Chapters 10 through 17 focus on specific actions managers can take to maximize their firms’ values As we noted above, most business students don’t plan to specialize in finance, so they might not think the “business finance” chapters are particularly relevant to Preface them This is not true, and in the later chapters we show that all really important business decisions involve all of the firm’s departments—marketing, accounting, production, and so on Thus, while capital budgeting can be thought of as a financial decision, marketing people provide inputs on likely unit sales and sales prices, manufacturing people provide inputs on costs, and so on Moreover, capital budgeting decisions influence the size of the firm, its products, and its profits, and those factors affect all the firm’s employees, from the CEO to the mail room staff STRUCTURAL CHANGES We made two important structural changes in this new edition: We moved the material on financial markets and institutions from Chapter to Chapter Markets and institutions follow naturally from Chapter 1, and this material provides useful background information for the remainder of the book We moved the time value of money (TVM) chapter from Chapter to Chapter Under the previous structure, we covered TVM concepts, then covered the accounting and financial markets chapters before applying TVM concepts to bond and stock valuation We liked the idea of covering TVM early, but we concluded that it was pedagogically better to cover TVM concepts and then immediately focus on applications, as we now These changes improve the flow of the text significantly—there is a much smoother transition from chapter to chapter in the first part of the book OTHER CHANGES We made many other changes, but the following are the most significant: 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 files, which facilitated shifting things around to improve transitions and flow Students will find it easier to read the book than in the past Beginning-of-Chapter Vignettes and Within-Chapter Boxes Many events have transpired in the financial 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 fired; and so on We use these events as the subjects of many vignettes and boxes, and they illustrate the points made in the chapters very well 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 Excel Spreadsheets, especially Excel, are becoming increasingly important in business, and students who are familiar with Excel have a significant advantage 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 Second, 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 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 v vi Preface financial problems can be set up and solved very efficiently with Excel Students who are not familiar with Excel should also be motivated to learn something about it 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 clarity, 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 realtime 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 questions, and the test bank questions and problems are similar to the EOC materials If students read the text, the self-test questions as they go along, and then work a sampling of the EOC questions and problems, they should well on exams drawn from the test bank Accounting Statements and Free Cash Flow Most students in the basic finance course are familiar with balance sheets and income statements, but many don’t really understand the statement of cash flows and its relationship to free cash flows Reviewers told us that in the last edition we tried to too many things—like present alternative ways to calculate free cash flow—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 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 complex projects in Chapter 12 For this edition, we rewrote Chapter 12, continuing 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 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 significant earnings decline, and that led to a sharp drop in GE’s stock price We used this example to illustrate the importance of accurate forecasts and to liven up our discussion of strategic financial planning In addition, we used an improved Excel model to streamline our illustrative forecast 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 reflects 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 specifically 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 invaluable 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 benefited from the work of Mike Ehrhardt and Phillip Preface 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 outstanding 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 edition 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 Pacific 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 vii viii Preface We would also like to thank the following professors, whose reviews and comments 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 Chaffin 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 Wafica 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 Preface 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 MedewitzDiamond 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 Sfiridis 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 Smith ix A-28 Appendix C Selected Equations and Tables Chapter Current assets Current ratio ‫ _ ؍‬ Current liabilities Current assets ؊ Inventories Quick, or acid test, ratio ‫ _ ؍‬ Current liabilities Sales Inventory turnover ratio ‫ ؍‬ Inventories Receivables Receivables ‫ _ ؍‬ Days sales outstanding (DSO) ‫ _ ؍‬ Average sales per day Annual sales/365 Sales Fixed assets turnover ratio ‫ ؍‬ Net fixed assets Sales Total assets turnover ratio ‫ ؍‬ Total assets Total debt Debt ratio ‫ ؍‬ Total assets EBIT Times-interest-earned (TIE) ratio ‫ ؍‬ Interest charges D/E D/A and D/A ‫ _ ؍‬ D/E ‫ _ ؍‬ ؊ D/A ؉ D/E EBITDA ؉ Lease payments EBITDA coverage ‫ _ ؍‬ Interest ؉ Principal payments ؉ Lease payments Operating income (EBIT) Operating margin ‫ ؍‬ Sales income Profit margin ‫ ؍‬Net Sales Net income Return on total assets (ROA) ‫ ؍‬ Total assets EBIT Basic earning power (BEP) ‫ ؍‬ Total assets Net income ؉ Interest Return on investors’ capital (ROIC) ‫ ؍‬ Debt ؉ Equity Net income Return on common equity (ROE) ‫ ؍‬ Common equity Price per share Price/Earnings (P/E) ratio ‫ ؍‬ Earnings per share Common equity Book value per share ‫ _ ؍‬ Shares outstanding Market price per share Market/book ratio (M/B) ‫ ؍‬ Book value per share ROE ‫ ؍‬Profit margin ؋ Total assets turnover ؋ Equity multiplier Net income ؋ Sales Total assets ‫ ؍‬ ؋ _ Sales Total assets Total common equity EVA ‫ ؍‬EBIT(1 ؊ Corporate tax rate) ؊ (Total investors’ capital) ؋ (After-tax cost of capital) EVA ‫ ؍‬Net income ؊ (Equity capital) ؋ (Cost of equity capital) ‫( ؍‬Equity capital)[Net income/Equity capital ؊ Cost of equity capital] ‫( ؍‬Equity capital)(ROE ؊ Cost of equity capital) Chapter Future value ‫ ؍‬FVN ‫ ؍‬PV(1 ؉ I)N FVN Present value ‫ ؍‬PV ‫ _ ؍‬ (1 ؉ I)N FVAN ‫ ؍‬PMT(1 ؉ I)N-1 ؉ PMT(1 ؉ I)N-2 ؉ PMT(1 ؉ I)N-3 ؉ ؉ PMT(1 ؉ I)0 [ (1 ؉ I)N ؊ ‫ ؍‬PMT I ] Appendix C Selected Equations and Tables FVAdue ‫ ؍‬FVAordinary(1 ؉ I) PVAN ‫ ؍‬PMT/(1 ؉ I)1 ؉ PMT/(1 ؉ I)2 ؉ ؉ PMT/(1 ؉ I)N [ 1 ؊ _ (1 ؉ I)N ‫ ؍‬PMT I ] PVAdue ‫ ؍‬PVAordinary(1 ؉ I) PV of a perpetuity ‫ ؍‬PMT I N CFt CF1 CF2 CFN ؉ _ PV ‫ ؍‬ 1؉ 2؉ N‫؍‬⌺ (1 ؉ I)t (1 ؉ I) (1 ؉ I) (1 ؉ I) t‫؍‬1 Stated annual rate ‫ ؍‬I/M Periodic rate (IPER) ‫ ؍‬ Number of payments per year Number of periods ‫( ؍‬Number of years)(Periods per year) ‫ ؍‬NM ͧ INOM Effective annual rate (EFF%) ‫ ؍‬1 ؉ M ͨ M ؊ 1.0 Chapter Quoted interest rate (r) ‫ ؍‬r* ؉ IP ؉ DRP ؉ LP ؉ MRP ؉ DRP ؉ LP ؉ MRP rRF ‫؍‬ rT-bill ‫ ؍‬rRF ‫ ؍‬r* ؉ IP rT-bond ‫ ؍‬r*t ؉ IPt ؉ MRPt rC-bond ‫ ؍‬r*t ؉ IPt ؉ MRPt ؉ DRPt ؉ LPt rRF with cross-product term ‫ ؍‬r* ؉ I ؉ (r* ؋ I) Chapter INT ؉ _ INT ؉ ؉ _ INT ؉ _ M Bond’s value (VB) ‫ _ ؍‬ (1 ؉ rd)1 (1 ؉ rd)2 (1 ؉ rd)N (1 ؉ rd)N N INT ؉ _ M ‫ ؍‬⌺ _ t (1 ؉ rd)N t‫؍‬1 (1 ؉ rd) N Call price INT ؉ Price of callable bond ‫ ؍‬⌺ _ t (1 ؉ rd)N t‫؍‬1 (1 ؉ rd) 2N INT/2 ؉ M VB ‫ ؍‬⌺ _ t (1 ؉ rd/2)2N t‫؍‬1 (1 ؉ rd/2) Chapter Expected rate of return (ˆr) ‫ ؍‬P1r1 ؉ P2r2 ؉ ؉ PNrN N ‫ ؍‬⌺ Pi ri i‫؍‬1 Standard deviation ‫ ؍‬σ ‫؍‬ Estimated σ ‫؍‬ √ √ _ N ⌺ (r ؊ rˆ) i‫؍‬1 i N (r¯ ؊ r¯ ) ⌺ t‫؍‬1 t Avg NϪ1 σ Coefficient of variation ‫ ؍‬CV ‫ ؍‬ rˆ rˆ ‫ ؍‬w rˆ ؉ w rˆ ؉ ؉ w rˆ p 1 N ‫ ؍‬⌺ wi rˆi i‫؍‬1 2 N N Pi A-29 A-30 Appendix C Selected Equations and Tables bp ‫ ؍‬w1b1 ؉ w2b2 ؉ ؉ wNbN N ‫ ؍‬⌺ wi bi i‫؍‬1 RPi ‫( ؍‬RPM)bi ri ‫ ؍‬rRF ؉ (rM ؊ rRF)bi Chapter Value of stock (Pˆ0) ‫ ؍‬PV of expected future dividends D2 D1 Dؕ ؉ ؉ ؉ ‫ _ ؍‬ (1 ؉ rs )ؕ (1 ؉ rs)1 (1 ؉ rs )2 ؕ Dt ‫ ؍‬⌺ _ t t‫؍‬1 (1 ؉ rs ) D0(1 ؉ g)1 D D0(1 ؉ g)ؕ (1 ؉ g)2 _ ؉ _ Constant growth stock: Pˆ0 ‫ _ ؍‬ ؉ ؉ (1 ؉ rs)ؕ (1 ؉ rs ) (1 ؉ rs ) D0(1 ؉ g) _ D1 ‫ ؍‬ rs ؊ g ‫ ؍‬rs ؊ g Expected rate ‫ ؍‬Expected ؉ Expected growth rate, or dividend yield of return capital gains yield D                           rˆs ‫ ؍‬1 ؉ g P0 Growth rate ‫( ؍‬1 – Payout ratio)ROE Zero growth stock: Pˆ0 ‫ ؍‬D r s DN ؉ Horizon value ‫ ؍‬PˆN ‫ _ ؍‬ rs ؊ g D1 D2 DN DN؉1 Dؕ ؉ _ ؉ ؉ _ ؉ _ ؉ ؉ _ Nonconstant: Pˆ0 ‫ _ ؍‬ (1 ؉ rs)ؕ (1 ؉ rs)1 (1 ؉ rs)2 (1 ؉ rs)N (1 ؉ rs)N؉1 ˆ P D2 DN D1 N ؉ ؉ ؉ ؉ ‫ ؍‬ (1 ؉ rs )1 (1 ؉ rs )2 (1 ؉ rs )N (1 ؉ rs )N ˆ ‫ ؍‬PV of nonconstant dividends ؉ PV of horizon value, P N Market value of company (V ) ‫ ؍‬PV of expected future free cash flows Company FCF1 FCF2 FCFؕ ‫ _ ؍‬ ؉ _ ؉ ؉ _ (1 ؉ WACC)ؕ (1 ؉ WACC)1 (1 ؉ WACC)2 Horizon value (VCompany at t‫؍‬N) ‫ ؍‬FCFN؉1/(WACC ؊ gFCF) Market value of equity ‫ ؍‬Book value ؉ PV of all future EVAs Dp Vp ‫ _ ؍‬ r p Dp rˆp ‫ _ ؍‬ Vp Chapter 10 ͧ ͨͧ ͨ ͧ ͨͧ ؉ wprp ͨͧ ͨͧ % of Cost of % After-tax % of Cost of WACC ‫ ؍‬of cost of ؉ preferred preferred ؉ common common equity equity debt debt stock stock ‫؍‬ wdrd(1 – T) ؉ wcrs ͨ Appendix C Selected Equations and Tables After-tax cost of debt ‫ ؍‬Interest rate on new debt – Tax savings ‫ ؍‬rd – rdT ‫ ؍‬rd(1 – T) Dp Component cost of preferred stock ‫ ؍‬rp ‫ _ ؍‬ Pp Required rate of return ‫ ؍‬Expected rate of return rs ‫ ؍‬rRF ؉ RP ‫ ؍‬D1/P0 ؉ g ‫ ؍‬rˆs rs ‫ ؍‬rRF ؉ (RPM)bi ‫ ؍‬rRF ؉ (rM – rRF)bi D1 D2 Dؕ Pˆ0 ‫ _ ؍‬ ؉ _ ؉ ؉ _ (1 ؉ rs)ؕ (1 ؉ rs)1 (1 ؉ rs)2 ؕ Dt ‫ ؍‬⌺ _ (1 ؉ rs)t t‫؍‬1 D1 Pˆ0 ‫ _ ؍‬ rs ؊ g D rs ‫ ؍‬rˆs ‫ ؍‬1 ؉ Expected g P0 D1 ؉g Cost of equity from new stock ‫ ؍‬re ‫ ؍‬ P0 (1 ؊ F) Retained earnings Addition to retained earnings for the year ‫ ؍‬ breakpoint Equity fraction Chapter 11 CF1 CF2 CFN NPV ‫ ؍‬CF0 ؉ _ ؉ _ ؉ ؉ _ (1 ؉ r)1 (1 ؉ r)2 (1 ؉ r)N N CFt ‫ ؍‬⌺ (1 ؉ r)t t‫؍‬0 CF1 CF2 CFN ؉ _ ؉ ؉ _ ‫؍‬0 CF0 ؉ _ (1 ؉ IRR)1 (1 ؉ IRR)2 (1 ؉ IRR)N N CFt ‫؍‬0 ⌺ (1 ؉ IRR) t‫؍‬0 t N N ⌺ t‫؍‬0 CIFt(1 ؉ r)N؊t ⌺ COFt t‫؍‬0 ‫؍‬ (1 ؉ r)t (1 ؉ MIRR)N TV PV costs ‫ _ ؍‬ (1 ؉ MIRR)N Unrecovered cost at start of year Payback ‫ ؍‬Number of years prior to full recovery ؉ Cash flow during full recovery year Chapter 13 EBIT ‫ ؍‬PQ – VQ – F ‫ ؍‬0 F QBE ‫ _ ؍‬ P؊V bL ‫ ؍‬bU[1 ؉ (1 ؊ T)(D/E)] bU ‫ ؍‬bL/[1 ؉ (1 ؊ T)(D/E)] A-31 A-32 Appendix C Selected Equations and Tables Chapter 14 Dividends ‫ ؍‬Net income ؊ Retained earnings required to help finance new investements ‫ ؍‬Net income ؊ [(Target equity ratio)(Total capital budget)] Chapter 15 Payables Average Inventory Cash conversion ؉ collection ؊ deferral ‫ ؍‬conversion period period period cycle Inventory Inventory conversion period ‫ _ ؍‬ Cost of goods sold per day Receivables Average collection period (ACP or DSO) ‫ _ ؍‬ Sales/365 Payables Payables Payables deferral period ‫ ؍ ؍‬ Purchases per day Cost of goods sold/365 Accounts receivable ‫ ؍‬Sales per day ؋ Length of collection period Receivables ‫( ؍‬ADS)(DSO) Discount % 365 ؋ Nominal annual cost of trade credit ‫ ؍‬ 100 ؊ Discount % Days credit is Discount ؊ outstanding period Nominal rate Simple interest rate per day ‫؍‬ Days in year Interest charge for month ‫( ؍‬Rate per day)(Amount of loan)(Days in month) Interest paid Approximate annual rateAdd-on ‫ ؍‬ (Amount received)/2 Chapter 16 AFN Projected asset increase ؊ Spontaneous liabilities increase ؊ Increase in retained earnings ‫( ؍‬A0*/S0)⌬S ؊ (L0*/S0)⌬S ؊ MS1(1 – Payout) ‫؍‬ Actual sales Full capacity sales ‫ ؍‬ Percentage of capacity at which fixed assets were operated Actual fixed assets Target fixed assets/Sales ‫ ؍‬ Full capacity sales Required level of fixed assets ‫( ؍‬Target fixed assets/Sales)(Projected sales) Chapter 17 US$ required Direct quotation: unit of foreign currency Units of foreign currency Indirect quotation: US$ (1 ؉ rh) Forward exchange rate _ ‫؍‬ (1 ؉ rf ) Spot exchange rate Ph ‫( ؍‬Pf )(Spot rate) P Spot rate ‫ ؍‬h Pf INDEX A Abandonment option, 383–384 Abercrombie & Fitch, 533 Accounting income vs cash flow, 365 Accounting standards, global, 97 Accounts payable, 493–495 Accounts receivable, 490–493 modifying, 524 Accruals, 500 Accrued liabilities, 500 Actual (realized) rate of return (rˉ), 276 Additional funds needed (AFN), 514 Add-on interest, 498 AFLAC, 534 AFN equation, 514–518 After-tax cost of debt, rd(1 – T), 311 Agency theory, 18 Aggressive approach, 476 Aging schedule, 493 Airbus, 335, 355 Allied Components Company, 362 Allied Food Products, 69, 87, 105, 108, 195, 197, 256, 279, 289, 307–309, 316, 394, 473, 482–485, 492, 493, 512–525 balance sheet, 58 summary of ratios, 104 Allocation, capital, 28–29 Alternative estimates, averaging the, 317 Alternative minimum tax (AMT), 72 Amazon.com, 270 American Depository Receipts (ADRs), 554 American Development Corporation (ADC), 460 American Stock Exchange, 38 American terms, 543 Amortization, 63 Amortization schedule, 152 Amortized loan, 151–152 Annual compounding, 146–148 Annual depreciation rates, 397 Annual percentage rate (APR), 148 Annual report, 55 Annuity, 134–135 Annuity due, 135 future rate of, 137 Annuity payments (PMT), finding, 139 Apple Computer, 9, 10, 60, 270, 287, 368 Appreciation of currency, 541, 551 Arbitrage, 546 Ask price, 40 Asset-based financing, 500 Asset management ratios, 89–92 Assets, opportunity costs association with, 367 Asymmetric information, 423 AT&T, 16, 19 Atlantic Richfield, 460 Auction rate securities (ARS), 173 Average collection period (ACP), 479 Average stock’s beta, 245 Average tax rate, 70 B Balance sheet, 57–61 Allied Food, 58 forecasted, 519 Bank, commercial, 34 investment, 34 Bank loans, 495–499 cost of, 497 Bank of America, 34, 36 Bankruptcy, and reorganization, 219 effect on capital structure, 421 Base-case NPV, 376 Base-case scenario, 378 Basic earning power (BEP) ratio, 98 Before-tax cost of debt, 310 Behavioral finance theory, 49 Behavioral finance, 49 Benchmarking, 105–106 Best Buy Company, 472, 488 Best-case scenario, 378 Beta and CAPM, concerns about, 257 Beta coefficient, 245 Beta coefficient, changes in, 256 Beta risk, within-firm and, 381–382 Bid-ask spread, 40 Bid price, 40 Billingham Corporation, 215 Bird-in-the-hand fallacy, 443 Boeing, 335, 355 Bond(s), 195 and valuation, 194 bankruptcy and reorganization, 219 characteristics of, 196–200 issuers, 195–196 other features, 199–200 risk in market, 194 with semiannual coupons, 209–210 Bond markets, 220 Bond ratings, 215 changes in, 218 criteria for, 216 importance of, 217 Bond riskiness, assessing, 210–214 Bond valuation, 200–203 Bond values, changes over time, 206–209 Bond yields, 203–205 Bondholders vs stockholders, 20 Bond-yield-plus-risk-premium approach, 315 Budgeting methods, conclusions, 355–356 Business activity, 185 climate, 557 decisions, interest rates and, 185–187 ethics, 15–18 company behavior, 15 unethical behavior, 16 organization, forms of, 6–8 risk, 402, 403–413 trends, important, 14 C Call provision, 198 Campus Deli Inc., 435 Cannibalization, 367, 371 Capital, alternative sources of, 456 external, cost of raising, 319 increased cost of, 318 Capital allocation process, 28–29 Capital asset pricing model (CAPM), 240 Capital budget, optimal, 385 Capital budgeting, 336 Asian/Pacific region, 380 basics of, 335 competition in aircraft industry, 335 decision criteria, 356 international, 556–558 I-1 I-2 Index Capital budgeting (continued) overview, 336–338 risk analysis in, 374–375 Capital budgeting methods, conclusions, 355–356 Capital component, 309 Capital gain(s), reasons preferred, 443 vs dividends, 441–444 Capital gain or loss, 70 Capital gains yield, 276 Capital intensity ratio, 517 Capital market, 30 international money and, 551–554 Capital rationing, 385 Capital structure, auto companies, 438 determining optimal, 413–419 effect of bankruptcy, 421 effect of taxes, 420 global, 428 international, 558–559 optimal, 416 signaling theory, 423 target, 401–402 trade-off theory, 422 variations in, 427–429 Capital structure and leverage, 400 debt and, 400 Capital structure changes, WACC and, 414 Capital structure decisions, checklist for, 425–427 Capital structure theory, 419–425 CAPM, 240–249 and Beta, concerns about, 257 approach, 314 Captive finance companies, 492 Carolina Power & Light (CP&L), 28, 31 Cash, and marketable securities, 485–488 currency, 486 demand deposits, 486 Cash budget, 482–485 Cash conversion cycle (CCC), 479–481 Cash flow, incremental, 366 timing of, 366 earnings, and dividends, 451 normal and nonnormal, 344 Cash flow (CF1), 143 Cash flow estimation, and risk analysis, 364 concepts in, 364–368 Home Depot growth, 364 Cash flow statement, 63–67 massaging, 66 Cash flow vs accounting income, 365 CCC, calculating the targeted, 479, 480 see also cash conversion cycle Changing ratios, analyzing effects of, 524–525 Chevron Corporation, 271, 451, 452, 453, 459 Chrysler, 492 Circuit City, 270 Cisco Systems, 45 Citi Smith Barney, 34, 316 Citibank, 34 Citigroup, 16, 29, 36, 37, 47, 54, 229, 273, 499, 534 Citrus Products Inc., 563 Class life, 397 Classified stock, 272 Clientele effect, 445 Clienteles, 445 Closely held corporation, 40 Coca-Cola, 14, 19, 178, 179, 198, 460, 534 Coefficient of variation (CV), 238 Coleman Technologies, 333 Colgate-Palmolive, 534 Collection float, 487 Collection policy, 490 Commercial bank, 34 Commercial paper, 499 Common size analysis, 87 Common stock, cost of new, 318–320 external equity, 320 flotation costs, 318 increased cost of capital, 318 market for, 40–43 types of, 272–273 valuing, 290 Compensating balance, 495 Compound interest, 126 Compounding process, graphic view, 130 Compounding, 125 Conservative approach, 478 Consol, 141 Constant growth (Gordon) model, 278 Constant growth model, conditions for, 282 Constant growth stocks, 278–283 illustration, 279 Constraints, dividend, 456 Convertible bond, 199 Corporate (within-firm) risk, 375 Corporate bonds, 196 types of, 215 Corporate governance, 15 Corporate objectives, statement of, 511 Corporate raider, 19 Corporate scope, 511 Corporate strategies, 511 Corporate taxes, 72 Corporate valuation model, 286–291 Corporate valuation vs discounted dividend models, 290 Corporation, closely held, 40 global, 535–538 multinational, 535–538 publicly owned, 41 valuing the entire, 286–291 Correlation, 243 Correlation coefficient (␳), 243 Cost of capital, 306 adjusting for risk, 323 After-tax cost of debt, rd(1 – T), 311 creating value at GE, 306 global variations in, 322 problems with estimates, 325 risk-adjusted, 375 Cost of debt, rd(1 – T), 310–312 money, 163–164 new common stock (re), 313 preferred stock (rp), 312 retained earnings (rs), 313 Costly trade credit, 495 Country risk, 554 measuring, 555 Coupon interest rate, 197 Coupon payment, 197 Coupons, semiannual, bonds with, 209–210 Credit period, 490 Credit policy, 490 Credit policy, setting and implementing, 491 Credit score, 491 Credit standards, 490 Credit terms, 491 Cross rate, 542 Crossover rate, 350 Cumulative voting, 271 Currency board arrangement, 541 Currency, 486 Current asset financing policies, 475–478 financing policy, 476 investment policies, 474–475 Index Current ratio, 88 Current yield, 205 D D’Leon Inc., 81, 118 Days sales outstanding (DSO), 90 Dealer market, 40 Debenture, 215 Debt, 400 Debt financing, used to constrain managers, 424 Debt management ratios, 92–95 Debt ratio, 94 Decision tree, 383 Declaration date, 453 Default risk, 214–220 Default risk premium (DRP), 172 Dell, 287, 368, 460 Delta Airlines, 173, 241 Demand deposits, 486 Depreciation of currency, 541, 550 Depreciation rates, effect of different, 371 Depreciation, 63 Derivative, 33 Determinants of market interest rates, 168–174 Deutsche Bank, 47 Devaluation of currency, 540 Direct investments, 551 Direct quotations, 544 Discount bond, 202 Discount on forward rate, 545 Discounted cash flow (DCF) approach, 315 Discounted dividend model, 275–278 vs corporate valuation, 290 Discounted payback, 354 Discounting, 131 Discounting process, graphic view, 132 Discounts, 490 Diversifiable risk, 243 Diversifying overseas, benefits of, 250 Dividend distribution, 440 Dividend irrelevance theory, 442 Dividend policy, alternative capital, 456 constraints on, 456 effects of, 457 factors influencing, 455–457 in practice, establishing, 446–454 investment opportunities, 456 issues in, 444–445 Dividend reinvestment plan (DRIP), 454–455 Dividend yield, 276 Dividend yields around the world, 449 Dividends, earnings, and cash flows, 451 reasons preferred, 442 vs capital gains, 441–444 vs growth, 280–282 Dividend-yield-plus-growth-rate approach, 315 Domestic vs multinational financial management, 538–539 Dow Chemical, 534 Dow Jones Industrial Average, 45 DuPont equation, 101–102 Duration, 211 Dutch auction, 43 E Eagle, 81 Earnings, cash flows, and dividends, 451 EBITDA, 63 Economic value added (EVA) vs net income, 108 Effective (equivalent) annual rate (EFF% or EAR), 149 Efficient markets hypothesis (EMH), 47, 49 semi-strong form, 47 strong form, 47 weak form, 47 Electronic communications networks (ECNs), 38 Enron, 11, 14, 17, 15, 16, 106, 219 Equilibrium stock prices, changes in, 302–303 Equilibrium, 12, 302 Eurobond, 552 Eurocredits, 551 Eurodollar, 551 European terms, 543 EVA approach, 290 Excess capacity adjustments, 517 Exchange rate, 540, 550–551 Exchange rate risk, 554 Exchange traded funds, 35 Ex-dividend date, 453 Executive compensation, intrinsic values, stock prices, and, 10–13 Expansion project, analysis of, 369–372 Expected dividends, basis for stock value, 277 Expected inflation, impact of, 253 Expected rate of return, rˆ, 234, 276 Expected return on a portfolio, (rˆp), 241 Expected risk premium, 315 Expected total return, 276 External capital, cost of raising, 319 External equity, when to use, 320 Externality, 367 environmental, 368 negative within-firm, 367 positive within-firm, 368 ExxonMobil, 14, 215, 299 F Fannie Mae, 19 Federal budget deficits or surpluses, 184 Federal reserve policy, 183 Finance, capital markets, corporate, defined, 4–6 investments, jobs in, vs economics and accounting, within an organization, Finance theory, behavioral, 49 Financial analysis on the Internet, 68 Financial calculators, 127, 128 Financial flexibility, 402, 426 Financial institutions, 34–38 Financial leverage, 409 Financial management, multinational, 534 multinational vs domestic, 538–539 overview, striking the right balance, Financial markets, 30–34 and institutions, 26 recent trends, 31 types of, 30–31 Financial plan, 512 Financial planning and forecasting, 509 strategic, 511–512 Financial report, balance sheet, 57–61 Financial risk, 403–407, 408–413 defined, 408 Financial services corporation, 34 Financial statement analysis, 85 analyzing stocks, 85 Financial statements and reports, 55–56 cash flow, and taxes, 54 forecasted, 518–522 quality of, 54 warning signs, 106 Financing policies, current asset, 475–478 I-3 I-4 Index Financing, short-term, 500–501 Fixed assets turnover ratio, 91 Fixed exchange rate, 540 Fixed-peg arrangement, 542 Fixed-rate bond, 197 Float, 487 Floating exchange rate, 540 Floating-rate bond, 197 Flotation cost, F, 319 added to project cost, 318 Flotation cost adjustment, 319 Ford Motor Company, 43, 122, 241, 451, 492 Forecasted balance sheet, 519 Forecasted financial statements, 518–522 inputs, 518 ratios and EPS, 520 used for operations, 520 Forecasted income statement, 519 Foreign bond, 196, 552 Foreign exchange rate quotations, 542–544 Foreign trade deficit, 184 Formula approach, 127 Forward exchange rate, 540, 545 Founders’ shares, 273 Fractional time periods, 150 Free cash flow, 68 and small businesses, 69 Free trade credit, 495 Freely-floating regime, 541 Frito-Lay, 81 Funds, spontaneously generated, 514 Future value (FVN), 125–130 Futures market, 30 FVAN, 135 G General Electric, 2–3, 9, 12, 14, 215, 231, 232, 306, 355, 492, 509–512 creating value at, 306 General Motors, 19, 231, 232, 273, 451, 492 General Motors Acceptance Corporation (GMAC), 491 Georgia-Pacific Corporation, 417 Global accounting standards, 97 Global corporations, 535–538 Global perspectives boxes, 14, 38, 97, 250, 322, 380, 428, 449, 555 Global variations in the cost of capital, 322 Going public, 41 Goldman Sachs, 47 Goodyear, 460 Google Inc., 3, 43, 45, 283, 287 Gordon-Lintner’s theory, 443 Greenmail, 460 Growth rate, g, 276 Growth vs dividends, 280–282 Gulf Oil, 271 H Half-year convention, 397 Hamada equation, 415 Hedge funds, 35 Herman Miller, Inc., 489 Hewlett-Packard, 7, 368, 459, 534 Historical risk premium, 315 Holder-of-record date, 453 Home Depot Inc., 14, 364, 366, 367, 460, 475, 488 Horizon (terminal) value, 284 Hostile takeover, 19 Hughes Aircraft, 273 Humped yield curve, 176 Hypothesis, 444 I IBM, 14, 19, 33, 368, 460, 492, 534 Incentive signaling, 444 Income bond, 200 Income statement, 61–63 forecasted, 519 Income taxes, 70–75 Incremental cash flow, 366 Indenture, 215 Independent projects, 340, 352 Indexed (purchasing power) bond, 200 Indirect quotations, 544 Inflation, 163 and interest rates, link between, 178 impact of expected, 253 interest rates and exchange rates, 550–551 Inflation premium (IP), 170 Information content (signaling), 444 Initial public offering (IPO) market, 41 Inputs, changes to, 372 Intel, 45, 368 Interbank foreign currency quotations, 543 Interest, simple vs compound, 126 Interest charges, calculating, 497, 498 Interest rate, I, finding, 133–134, 140 Interest rate(s), 162, 550–551 and business decisions, 185–187 and inflation, link between, 178 comparing, 148–150 Effective (equivalent) annual rate (EFF% or EAR), 149 term structure of, 175–176 yield curve used to estimate future, 180–182 Interest rate (price) risk, 210 Interest rate levels, 165–168 macroeconomic factors influence, 183–185 Interest rate parity, 546–547 Interest rate risk, 173 Internal rate of return (IRR), 341–344 International capital budgeting, 556–558 International capital structures, 558–559 International credit markets, 551 International factors, 184 International money and capital markets, 551–554 International monetary system, 540–542 International money terminology, 540 International stock markets, 552, 553 International stocks, investing in, 555–556 Internet, financial analysis on the, 68 Intrinsic value vs stock price, 273–275 Intrinsic value, 11, 274 investor concerns, 274 stock prices, and executive compensation, 10–13 Inventories, 488–489 modifying, 524 Inventory conversion period, 479 Inventory turnover ratio, 90 Inverted (abnormal) yield curve, 176 Investing overseas, 554 Investment, vertically integrated, 536 Investment bank, 34 Investment horizon, 213 Investment opportunities, 456 Investment policies, current asset, 474–475 Investment-grade bond, 216 Investor, marginal, 12 IRR compared to NPV, 343 J JPMorgan Chase, 34 Junk bond, 216 Index K Keebler Foods Co., 400 Kellogg Co., 400 L Law of one price, 547 Leverage, capital structure and, 400 LIBOR, 551 Limited liability company (LLC), Limited liability partnership (LLP), Line of credit, 496 Liquid asset, 88 Liquidity premium (LP), 172 Liquidity ratios, 88, 88–89 Lockbox, 486 Low-regular-dividend-plusextras, 451 M Macroeconomic factors, and interest rate levels, 183–185 Managed-float regime, 541 Managerial conservatism/ aggressiveness, 402 Managers, stockholders, and bondholders, conflicts between, 18–21 Managers vs stockholders, 18 Marginal investor, 12, 275 Marginal tax rate, 70 Market, measuring the, 45 Market (beta) risk, 375 Market efficiency, conclusions about, 50 Market for common stock, 40–43 Market instruments, summary of, 32 Market interest rates, determinants of, 168–174 Market portfolio, 244 Market price (P0), 11, 276 Market risk premium, 251 estimating, 252 Market risk, 243 Market value ratios, 99 Market, initial public offering (IPO), 41 Market/book (M/B) ratio, 100 Marketable securities, 487 cash and, 485–488 Markets, financial, 30–34 tale of three, 229 Maturity date, 197 Maturity matching approach, 476 Maturity risk premium (MRP), 173 McDonald’s, 534 global Big Mac prices, 548–549 Merrill Lynch, 16, 29, 47, 229, 273, 316, 499 Microsoft, 3, 7, 14, 28, 45, 271, 283, 368, 440, 459, 460, 469, 485, 487 Mission statement, 511 Moderate current asset policy, 475 Modified IRR (MIRR), 347–349 Modigliani-Miller theory, 419 Monetary arrangements, current, 541 Money market, 30 Money market funds, 35 Monte Carlo simulation, 379 Mortgage bond, 215 Multinational corporations, 535–538 Multinational financial management, 534 U.S firms, 534 vs domestic, 538–539 Multiple IRRs, 344, 344–345 Municipal bonds, 196 Mutual funds, 35 Mutual of Chicago Insurance Company, 298 Mutually exclusive projects, 340, 352 N Nasdaq, 38, 45 Negative working capital, operating with, 481 Net income vs economic value added (EVA), 108 Net present value (NPV), 338–341 Net present value profile, 349 Net working capital, 60, 339, 473 New World Chemicals Inc., 531 New York Stock Exchange, 38 Nominal (quoted) risk-free rate, rRF , 170 Nominal (quoted, or stated) interest rate, INOM, 148 Nonconstant growth stocks, valuing, 283–286 Nonnormal cash flows, 344 Normal cash flows, 344 Normal yield curve, 176 Northwest Milling Company, 198 NPV compared to IRR, 343 NPV profiles, 349–353 Number of periods (N), finding, 139 Number of years, N, finding, 134 O Operating breakeven, 405 Operating income, 61 Operating leverage, 405 Operating margin, 96 Operating plan, 512 Opportunity cost, 131, 367, 371 and assets, 367 Optimal capital budget, 385 Optimal capital structure, 401, 416 determining, 413–419 Optimal dividend policy, 442 Option value, 383 Ordinary (deferred) annuity, 135 Original issue discount (OID) bond, 197 Original maturity, 198 Over-the-counter (OTC) market, 39 Oversubscribed, 41 P P/E multiple approach, 290 Pacific Timber Company, 198 Par value, 197 Partnership, Payables deferral period, 479 Payback period, 353–355 Payment (PMT), 143 Payment date, 454 Payment float, 487 Payment procedures, 453 Permanent current assets, 476 Payout ratio, 446 Perpetuity, 141–142 Phillips Petroleum, 460 Physical location exchanges, 39 Political risk, 557 Porter Electronic Controls Inc., 457 Portfolio context, risk in, 240–249 Portfolio investments, 551 Portfolio risk, 242, 245 Post-audit, 386 Preemptive right, 272 Preferred stock, 291–292 Premium bond, 203 Premium on forward rate, 545 Present value (PV), 125, 131–133 of an ordinary annuity, 138–139 Price/earnings (P/E) ratio, 99 PricewaterhouseCoopers (PWC), 14 Primary market, 30 Prime rate, 497 Private equity companies, 36 Private market, 31 Probability distribution, 233 Procter & Gamble, 33, 283, 460 Production opportunities, 163 Profit margin, 96 I-5 I-6 Index Profitability ratios, 96–98 Progressive tax, 70 Promissory note, 495 Proprietorship, Proxy fight, 271 Proxy, 271 Public market, 31 Publicly owned corporation, 41 Purchasing power parity (PPP), 547–550 Pure expectations theory, 180 Putable bond, 200 PVAN, 138 Q Quick (acid test) ratio, 89 R Raider, corporate, 19 Rates of return, risk and, 229 Ratio analysis, 87 Ratios, analyzing effects of changing, 524–525 and EPS, 520 in different industries, 103 uses and limitations of, 106–108 Real option, 382–384 types of, 382 Real risk-free rate of interest (r*), 169 Realized rate of return (rˉ), 241 Regression, used to improve forecasts, 523–524 Regression analysis, 523 Regular interest, 498 Reinvestment rate assumptions, 346–347 Reinvestment rate risk, 174, 213 Relaxed current asset policy, 475 Relevant risk, 245 Reorganization, bankruptcy and, 219 Repatriation of earnings, 557 Replacement analysis, 372–374 Replacement projects, 366 Reports, financial, 55–56 Required rate of return (rs), 276 Required returns, 238 Reserve borrowing capacity, 424 Residual dividend model, 446, 447 Restricted current asset policy, 475 Retained earnings breakpoint, 320 Retention ratio, 514 Retirement concerns, 123 Return on common equity (ROE), 98 Return on total assets (ROA), 97 Returns, stock markets and, 43–46 Revaluation of currency, 540 Reverse splits, 458 Revolving credit agreement, 497 Risk, 163, 232 business, 402, 403–413 financial, 403–407, 408–413 interest rate, 173 measuring with historical data, 237 reinvestment rate, 174, 213 Risk analysis and cash flow estimation, 364 Home Depot growth, 364 in capital budgeting, 374–375 Risk and rates of return, 229 relationship, 251–257 Risk and return, trade-off between, 239 Risk aversion, 238–239 changes in, 255 Risk premium (RP), 239, 315 Risk-adjusted cost of capital, 375 RJR Nabisco, 271 ROE, potential misuses of, 108–109 ROE, see also return on common equity rRF , 169 S S corporation, 7, 75 Sales forecast, 512–513 Salomon Smith Barney, 37 Sarbanes-Oxley Act, Scenario analysis, 378 Sears, 492 Seasoned issue, 206 Secondary market, 30 Secured financing, 500 Secured loan, 500 Security in short-term financing, 500–501 Security market line (SML) equation, 253 Self-liquidating approach, 476 Semiannual compounding, 146–148 Semiannual coupons, bonds with, 209–210 Sensitivity analysis, 376 Share repurchases, 440 Shareholder distributions, dividends and share repurchases, 440 value, stock prices and, 8–10 wealth maximization, 9, 14 Short-term financing, use of security in, 500–501 Signal, 424, 444 Signaling theory, 423 Simple interest, 126, 498 Sinking fund provision, 199 Sinking funds, 199 Ski Equipment Inc., 506 Southeastern Steel Company, 468 Special studies, 525 Spontaneous funds, 500 Spontaneously generated funds, 514 Spot market, 30 Spot rate, 540, 545 Spreadsheets, 128 Stand-alone risk, 232, 233–240, 375 measuring, 236, 376–381 statistical measures of, 233 Standard deviation (sigma), 236, 237 Starbucks, 84, 270 Statement of cash flows, 63, 63–67 Statement of corporate objectives, 511 Statement of stockholders’ equity, 67 Stock, and valuation, 269 that doesn’t pay dividends, evaluating, 287 types of common, 272–273 valuation, searching for the right stock, 269 Stock dividends, 458 and stock splits, 457–459 Stock market, 38–40 and returns, 43–46 global indices, 552 OTC and Nasdaq, 39 physical location, 39 Stock market efficiency, 46–50 Stock market equilibrium, 301–303 Stock market reporting, 43 Stock market returns, 46 Stock market transactions, types of, 41 Stock prices, and shareholder value, 8–10 effect of split, 458 intrinsic values, and executive compensation, 10–13 recent trends, 231–232 vs intrinsic value, 273–275 Stock repurchases, 460, 459–463 advantages of, 461 conclusions on, 462 disadvantages of, 462 effects of, 460 Index Stock splits, 457 effect on stock prices, 458 Stock value, expected dividends as basis for, 277 Stockholder rights, control of the firm, 271 preemptive right, 272 Stockholder wealth maximization, Stockholders, legal rights and privileges, 270–272 vs bondholders, 20 vs managers, 18 Strategic business plan, 337 Stretching accounts payable, 495 Strategic planning, 511–512 Subordinated debenture, 215 Sunk cost, 366–367, 371 Supernormal (nonconstant) growth, 283 Supply chain management, 489 Survivor bias, 100 Survivorship bias, 252 Sustainable growth rate, 515 Symmetric information, 423 Synergy, 511 T Takeover, 271 hostile, 19 Target capital structure, 401, 401–402 Target cash balance, 483 Target payout ratio, 441 Target payout ratio, 446 Tax depreciation, 397–398 Tax loss carry-back or carryforward, 74 Taxes, corporate, 72 effect on capital structure, 420 income, 70–75 individual, 70 Teledyne, 460 Temporary current assets, 476 Tender offer, 460 Term structure of interest rates, 175–176 Terminal (horizon) date, 284 Texas Instruments, 460 3M’s cost of capital, 334 Time line, 124–125 Time preferences for consumption, 163 Time value of money, 123 Times-interest-earned (TIE) ratio, 95 Total assets, total debt to, 94 Total assets turnover ratio, 92 Total debt to total assets, 94 Total return, 207 Trade credit, 493 Trade-off theory, 422 Trading in foreign exchange, 544–546 Treasury bonds, 196 almost riskless, 171 Trend analysis, 100 Tyco, 18 U Unethical behavior, and employees, 17 consequences of, 16 Uneven (nonconstant) cash flows, 143–144 Uneven cash flow stream, future value of, 144–145 Uneven cash flows, solving for I, 145–146 Unlevered beta, 416 V Vertically integrated investment, 536 W WACC, and capital structure changes, 414 factors affecting, 321 factors firm can control, 322 factors firm cannot control, 321 see also weighted average cost of capital Wachovia, 34 Wal-Mart, 9, 10, 14, 340, 475, 488 Walt Disney Company, 18, 19, 198 Warrant, 199 Weighted average cost of capital (WACC), 310, 321 overview, 307–309 Wells Fargo, 34 Western Money Management Inc., 228 Whistle-blowers, protection for, 17 Window dressing techniques, 107 Within-firm and beta risk, 381–382 Working capital management, 472 Best Buy, 472 Working capital, 59, 473 background, 473–474 operating with negative, 481 WorldCom, 14, 16, 17, 54 Worst-case scenario, 378 X Xerox, 19, 459, 460, 535 Y Yahoo!, 68 Yield curve, 175 shape determined, 176–180 used to estimate future interest rates, 180–182 Yield spread, 217 Yield to call (YTC), 204 Yield to maturity (YTM), 203 Yogi Berra, 420 Z Zero coupon bond, 197 Zero growth stock, 282 I-7 This page intentionally left blank FREQUENTLY USED SYMBOLS/ABBREVIATIONS ACP ADR APR A/R b bL bU BEP BVPS CAPM CCC CF CFPS CV Dp Dt DCF D/E DPS DRIP DRP DSO EAR EBIT EBITDA EPS EVA F FCF FVN FVAN g I I/YR INT IP IPO IRR LP M M/B MIRR MRP MVA N NWC NPV P Pf Ph Average collection period American depository receipt Annual percentage rate Accounts receivable Beta coefficient, a measure of an asset’s riskiness Levered beta Unlevered beta Basic earning power Book value per share Capital Asset Pricing Model Cash conversion cycle Cash flow; CFt is the cash flow in Period t Cash flow per share Coefficient of variation Dividend of preferred stock Dividend in Period t Discounted cash flow Debt-to-equity ratio Dividends per share Dividend reinvestment plan Default risk premium Days sales outstanding Effective annual rate, EFF% Earnings before interest and taxes; operating income Earnings before interest, taxes, depreciation, and amortization Earnings per share Economic value added (1) Fixed operating costs (2) Flotation cost Free cash flow Future value for Year N Future value of an annuity for N years Growth rate in earnings, dividends, and stock prices Interest rate; also referred to as r Interest rate key on some calculators Interest payment in dollars Inflation premium Initial public offering Internal rate of return Liquidity premium Maturity value of a bond Market-to-book ratio Modified internal rate of return Maturity risk premium Market value added Calculator key denoting number of periods Net working capital Net present value (1) Price of a share of stock in Period t; P0 ϭ price of the stock today (2) Sales price per unit of product sold Price of good in foreign country Price of good in home country P/E PMT PPP PV PVAN Q QBE r r¯ rˆ r* rd re rf rh ri rM rNOM rp rPER rRF rs ␳ ROA ROE RP RPM RR S SML ⌺ ␴ t T TVN TIE V VB Vp VC WACC YTC YTM Price/earnings ratio Payment of an annuity Purchasing power parity Present value Present value of an annuity for N years Quantity produced or sold Break-even quantity (1) A percentage discount rate, or cost of capital; also referred to as I (2) Nominal risk-adjusted required rate of return “r bar,” historic, or realized, rate of return “r hat,” an expected rate of return Real risk-free rate of return Before-tax cost of debt Cost of new common stock (outside equity) Interest rate in foreign country Interest rate in home country Required return for an individual firm or security Return for “the market,” or an “average” stock Nominal rate of interest; also referred to as INOM (1) Cost of preferred stock (2) Portfolio’s return Periodic rate of return Rate of return on a risk-free security (1) Cost of retained earnings (2) Required return on common stock Correlation coefficient; also denoted as R when using historical data Return on assets Return on equity Risk premium Market risk premium Retention rate (1) Sales (2) Estimated standard deviation for sample data Security Market Line Summation sign Standard deviation Time period Marginal income tax rate A stock’s horizon, or terminal, value at t ϭ N Times interest earned Variable cost per unit Bond value Value of preferred stock Total variable costs Weighted averaged cost of capital Yield to call Yield to maturity ... Management CHAPTER An Overview of Financial Management PART Fundamental Concepts in Financial Management CHAPTER CHAPTER CHAPTER CHAPTER Financial Markets and Institutions Financial Statements, Cash... third ranking officer, is in charge of FIGURE 1-1 Finance within an Organization Board of Directors Chief Executive Officer (CEO) Chief Operating Officer (COO) Chief Financial Officer (CFO) Marketing,... firm’s profits 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 financial management