Foundations of Finance: The Logic and Practice of Financial Management, Tenth Edition
By Arthur J. Keown, John D. Martin and J. William Petty
Contents:
Preface xvii
PART 1 The Scope and Environment of Financial Management 2
1 An Introduction to the Foundations of Financial Management 2
The Goal of the Firm 3
Five Principles That Form the Foundations of Finance 4
Principle 1: Cash Flow Is What Matters 4
Principle 2: Money Has a Time Value 5
Principle 3: Risk Requires a Reward 5
Principle 4: Market Prices Are Generally Right 6
Principle 5: Conflicts of Interest Cause Agency Problems 8
The Essential Elements of Ethics and Trust 9
The Role of Finance in Business 10
Why Study Finance? 11
The Role of the Financial Manager 11
The Legal Forms of Business Organization 12
Partnerships 13
Corporations 13
Organizational Form and Taxes: The Double Taxation on Dividends
and Pass-Through Entities 14
S-Corporations and Limited Liability Companies (LLCs) 14
Which Organizational Form Should Be Chosen? 15
Finance and the Multinational Firm: The New Role 15
Developing Skills for Your Career 16
Chapter Summaries 17 • Review Questions 20 • Mini Case 21
2 The Financial Markets and Interest Rates 22
Financing of Business: The Movement of Funds Through the Economy 24
Public Offerings Versus Private Placements 25
Primary Markets Versus Secondary Markets 26
The Money Market Versus the Capital Market 27
Spot Markets Versus Futures Markets 27
Stock Exchanges: Organized Security Exchanges Versus Over-the-Counter Markets,
a Blurring Difference 27
Selling Securities to the Public 29
Functions 29
Distribution Methods 30
Private Debt Placements 31
Flotation Costs 33
Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley Act 33
Rates of Return in the Financial Markets 34
Rates of Return over Long Periods 34
Interest Rate Levels in Recent Periods 35
Interest Rate Determinants in a Nutshell 38
Estimating Specific Interest Rates Using Risk Premiums 38
Real Risk-Free Interest Rate and the Risk-Free Interest Rate 39
Real and Nominal Rates of Interest 39
Inflation and Real Rates of Return: The Financial Analyst’s Approach 41
The Term Structure of Interest Rates 43
Shifts in the Term Structures of Interest Rates 43
What Explains the Shape of the Term Structure? 45
Chapter Summaries 47 • Review Questions 50 • Study Problems 50, Mini Case 53
3 Understanding Financial Statements and Cash Flows 54
The Income Statement 56
The Makeup of an Income Statement 56
Walmart’s Income Statement 57
Restating Walmart’s Income Statement 59
The Balance Sheet 61
Types of Assets 62
Types of Financing 63
Walmart’s Balance Sheet 65
Working Capital 66
Measuring Cash Flows 69
Profits Versus Cash Flows 69
The Beginning Point: Changes in the Balance Sheet and Cash Flows 70
Statement of Cash Flows 71
Concluding Suggestions for Computing Cash Flows 78
What Have We Learned about Walmart? 79
The Limitations of Financial Statements and Accounting Malpractice 80
Chapter Summaries 80 • Review Questions 83 • Study Problems 84, Mini Case 91
Appendix 3A: Free Cash Flows 94
Computing Free Cash Flows 94
Computing Financing Cash Flows 96
Study Problems 97
4 Evaluating a Firm’s Financial Performance 100
The Purpose of Financial Analysis 100
Measuring Key Financial Relationships 103
Question 1: How Liquid Is the Firm—Can It Pay Its Bills? 105
Question 2: Are the Firm’s Managers Generating Adequate Operating Profits
on the Company’s Assets? 110
Managing Operations 112
Managing Assets 112
Question 3: How Is the Firm Financing Its Assets? 117
Question 4: Are the Firm’s Managers Providing a Good Return on the Capital
Provided by the Company’s
Shareholders? 120
Question 5: Are the Firm’s Managers Creating Shareholder Value? 124
The Limitations of Financial Ratio Analysis 129
Chapter Summaries 130 • Review Questions 133 • Study Problems 133, Mini Case 140
PART 2 The Valuation of Financial Assets 142
5 The Time Value of Money 142
Compound Interest, Future Value, and Present Value 144
Using Timelines to Visualize Cash Flows 144
Techniques for Moving Money Through Time 147
Two Additional Types of Time Value of Money Problems 152
Applying Compounding to Things Other Than Money 153
Present Value 154
Annuities 158
Compound Annuities 158
The Present Value of an Annuity 160
Annuities Due 162
Amortized Loans 163
Making Interest Rates Comparable 165
Calculating the Interest Rate and Converting It to an EAR 167
Finding Present and Future Values With Nonannual Periods 168
Amortized Loans With Monthly Compounding 171
The Present Value of an Uneven Stream and Perpetuities 172
Perpetuities 173
Chapter Summaries 174 • Review Questions 177 • Study Problems 177, Mini Case 185
6 The Meaning and Measurement of Risk and Return 186
Expected Return Defined and Measured 188
Risk Defined and Measured 191
Rates of Return: The Investor’s Experience 198
Risk and Diversification 199
Diversifying Away the Risk 200
Measuring Market Risk 201
Measuring a Portfolio’s Beta 208
Risk and Diversification Demonstrated 209
The Investor’s Required Rate of Return 212
The Required Rate of Return Concept 212
Measuring the Required Rate of Return 212
Chapter Summaries 215 • Review Questions 219 • Study Problems 219, Mini Case 224
7 The Valuation and Characteristics of Bonds 226
Types of Bonds 227
Debentures 227
Subordinated Debentures 228
Mortgage Bonds 228
Eurobonds 228
Convertible Bonds 228
Terminology and Characteristics of Bonds 229
Claims on Assets and Income 230
Par Value 230
Coupon Interest Rate 230
Maturity 230
Call Provision 230
Indenture 231
Bond Ratings 231
Defining Value 232
What Determines Value? 234
Valuation: The Basic Process 235
Valuing Bonds 236
Bond Yields 242
Yield to Maturity 242
Current Yield 244
Bond Valuation: Three Important Relationships 245
Chapter Summaries 250 • Review Questions 253 • Study Problems 254, Mini Case 257
8 The Valuation and Characteristics of Stock 258
Preferred Stock 260
The Characteristics of Preferred Stock 260
Valuing Preferred Stock 261
Common Stock 265
The Characteristics of Common Stock 265
Valuing Common Stock 267
The Expected Rate of Return of Stockholders 272
The Expected Rate of Return of Preferred Stockholders 273
The Expected Rate of Return of Common Stockholders 274
Chapter Summaries 277 • Review Questions 280 • Study Problems 280, Mini Case 283
9 The Cost of Capital 284
The Cost of Capital: Key Definitions and Concepts 285
Capital Structure 285
Opportunity Costs, Required Rates of Return, and the Cost of Capital 286
The Firm’s Financial Policy and the Cost of Capital 287
Determining the Costs of the Individual Sources of Capital 288
The Cost of Debt 288
The Cost of Preferred Stock 291
The Cost of Common Equity 292
The Dividend Growth Model and the Implied Cost of Equity 293
Issues in Implementing the Dividend Growth Model 294
The Capital Asset Pricing Model 295
Issues in Implementing the CAPM 296
The Weighted Average Cost of Capital 298
Capital Structure Weights 298
Calculating the Weighted Average Cost of Capital 299
Calculating Divisional Costs of Capital 301
Estimating Divisional Costs of Capital 301
Using Pure Play Firms to Estimate Divisional WACCs 301
Using a Firm’s Cost of Capital to Evaluate New Capital Investments 305
Chapter Summaries 307 • Review Questions 310 • Study Problems 310, Mini Cases 316
PART 3 Investment in Long-Term Assets 318
10 Capital-Budgeting Techniques and Practice 318
Finding Profitable Projects 319
Capital-Budgeting Decision Criteria 320
The Payback Period 320
The Net Present Value 324
Using Spreadsheets to Calculate the Net Present Value 327
The Profitability Index (Benefit–Cost Ratio) 327
The Internal Rate of Return 330
Computing the IRR for Uneven Cash Flows with a Financial Calculator 332
Viewing the NPV–IRR Relationship: The Net Present Value Profile 333
Complications with the IRR : Multiple Rates of Return 334
The Modified Internal Rate of Return (MIRR)2 335
Using Spreadsheets to Calculate the MIRR 338
A Last Word on the MIRR 339
Capital Rationing 339
The Rationale for Capital Rationing 340
Capital Rationing and Project Selection 341
Ranking Mutually Exclusive Projects 341
The Size-Disparity Problem 342
The Unequal-Lives Problem 343
Chapter Summaries 346 • Review Questions 349 • Study Problems 350, Mini Case 356
11 Cash Flows and Other Topics in Capital Budgeting 358
Guidelines for Capital Budgeting 359
Use Free Cash Flows Rather Than Accounting Profits 359
Think Incrementally 359
Beware of Cash Flows Diverted from Existing Products 360
Look for Incidental or Synergistic Effects 360
Work in Working-Capital Requirements 360
Consider Incremental Expenses 361
Remember That Sunk Costs Are Not Incremental Cash Flows 361
Account for Opportunity Costs 361
Decide If Overhead Costs Are Truly Incremental Cash Flows 361
Ignore Interest Payments and Financing Flows 362
Calculating a Project’s Free Cash Flows 362
What Goes into the Initial Outlay 362
What Goes into the Annual Free Cash Flows over the Project’s Life 363
What Goes into the Terminal Cash Flow 365
Calculating the Free Cash Flows 366
A Comprehensive Example: Calculating Free Cash Flows 370
Options in Capital Budgeting 374
The Option to Delay a Project 374
The Option to Expand a Project 375
The Option to Abandon a Project 376
Options in Capital Budgeting: The Bottom Line 376
Risk and the Investment Decision 376
What Measure of Risk Is Relevant in Capital Budgeting? 377
Measuring Risk for Capital-Budgeting Purposes with a Dose of Reality—
Is Systematic Risk All There Is? 378
Incorporating Risk into Capital Budgeting 379
Risk-Adjusted Discount Rates 379
Measuring a Project’s Systematic Risk 382
Using Accounting Data to Estimate a Project’s Beta 382
The Pure Play Method for Estimating Beta 383
Examining a Project’s Risk Through Simulation 383
Conducting a Sensitivity Analysis Through Simulation 385
Chapter Summaries 386 • Review Questions 388 • Study Problems 388, Mini Case 394
Appendix 11A: The Modified Accelerated Cost Recovery System 396
What Does All This Mean? 397
Study Problems 397
PART 4 Capital Structure and Dividend Policy 398
12 Determining the Financing Mix 398
Understanding the Difference Between Business and Financial Risk 400
Business Risk 401
Operating Risk 401
Break-Even Analysis 401
Essential Elements of the Break-Even Model 402
Finding the Break-Even Point 404
The Break-Even Point in Sales Dollars 405
Sources of Operating Leverage 406
Financial Leverage 408
Combining Operating and Financial Leverage 410
Capital Structure Theory 412
A Quick Look at Capital Structure Theory 414
The Importance of Capital Structure 414
Independence Position 414
The Moderate Position 416
Firm Value and Agency Costs 418
Agency Costs, Free Cash Flow, and Capital Structure 420
Managerial Implications 420
The Basic Tools of Capital Structure Management 421
EBIT-EPS Analysis 421
Comparative Leverage Ratios 424
Industry Norms 425
Net Debt and Balance-Sheet Leverage Ratios 425
A Glance at Actual Capital Structure Management 425
Chapter Summaries 428 • Review Questions 431 • Study Problems 432, Mini Cases 434
13 Dividend Policy and Internal Financing 438
How do Firms Distribute Firm Profits to their Stockholders? 439
Does Dividend Policy Matter to Stockholders? 440
Three Basic Views 440
Making Sense of Dividend Policy Theory 442
What Are We to Conclude? 445
The Dividend Decision in Practice 446
Legal Restrictions 446
Liquidity Constraints 446
Earnings Predictability 446
Maintaining Ownership Control 447
Alternative Dividend Policies 447
Dividend Payment Procedures 447
Stock Dividends and Stock Splits 448
Stock Repurchases 449
A Share Repurchase as a Dividend Decision 450
The Investor’s Choice 451
A Financing Decision or an Investment Decision? 452
Practical Considerations—The Stock Repurchase Procedure 452
Chapter Summaries 453 • Review Questions 455 • Study Problems 456, Mini Case 459
PART 5 Working-Capital Management and International Business Finance 460
14 Short-Term Financial Planning 460
Financial Forecasting 461
The Sales Forecast 461
Forecasting Financial Variables 461
The Percent of Sales Method of Financial Forecasting 462
Analyzing the Effects of Profitability and Dividend Policy on DFN 463
Analyzing the Effects of Sales Growth on a Firm’s DFN 464
Limitations of the Percent of Sales Forecasting Method 467
Constructing and Using a Cash Budget 468
Budget Functions 468
The Cash Budget 469
Chapter Summaries 471 • Review Questions 473 • Study Problems 473
15 Working-Capital Management 480
Managing Current Assets and Liabilities 481
The Risk–Return Trade-Off 482
The Advantages of Current versus Long-term Liabilities: Return 482
The Disadvantages of Current versus Long-term Liabilities: Risk 482
Determining the Appropriate Level of Working Capital 483
The Hedging Principle 483
Permanent and Temporary Assets 484
Temporary, Permanent, and Spontaneous Sources of Financing 484
The Hedging Principle: A Graphic Illustration 484
Using the Cash Conversion Cycle 486
Estimating the Cost of Short-Term Credit Using the Approximate Cost-of-Credit Formula 488
Evaluating Sources of Short-Term Credit 490
Unsecured Sources: Accrued Wages and Taxes 490
Unsecured Sources: Trade Credit 492
Unsecured Sources: Bank Credit 493
Finance at Work 495
Unsecured Sources: Commercial Paper 496
Secured Sources: Accounts-Receivable Loans 498
Secured Sources: Inventory Loans 500
Chapter Summaries 501 • Review Questions 504 • Study Problems 505
16 International Business Finance 510
The Globalization of Product and Financial Markets 511
Foreign Exchange Markets and Currency Exchange Rates 512
Foreign Exchange Rates 513
What a Change in the Exchange Rate Means for Business 513
Exchange Rates and Arbitrage 516
Asked and Bid Rates 516
Cross Rates 517
Types of Foreign Exchange Transactions 518
Exchange Rate Risk 520
Interest Rate Parity 522
Purchasing-Power Parity and the Law of One Price 523
The International Fisher Effect 524
Capital Budgeting for Direct Foreign Investment 524
Repatriation of Profits and Taxation of Profits Abroad 525
Foreign Investment Risks 525
Chapter Summaries 526 • Review Questions 529 • Study Problems 529, Mini Case 530
Web 17 Cash, Receivables, and Inventory Management
Available online at www.pearson.com/mylab/finance
Web Appendix A Using a Calculator
Available online at www.pearson.com/mylab/finance
Glossary 532
Indexes 541