Practical financial manager 4th ed william laser

Introduction to Financial Management, 1 CHAPTER 1 Foundations, 1 CHAPTER 2 Financial Background: A Review of Accounting, Financial Statements, and Taxes, 24 CHAPTER 3 Cash Flows and Fina

Practical Financial Management, Fifth Edition

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Introduction to Financial Management, 1 CHAPTER 1 Foundations, 1

CHAPTER 2 Financial Background: A Review of Accounting,

Financial Statements, and Taxes, 24

CHAPTER 3 Cash Flows and Financial Analysis, 63

CHAPTER 4 Financial Planning, 116

CHAPTER 5 The Financial System, Corporate Governance, and Interest, 168

Discounted Cash Flow and the Value of Securities, 219 CHAPTER 6 Time Value of Money, 221

CHAPTER 7 The Valuation and Characteristics of Bonds, 270

CHAPTER 8 The Valuation and Characteristics of Stock, 328

CHAPTER 9 Risk and Return, 369

Business Investment Decisions—Capital Budgeting, 419 CHAPTER 10 Capital Budgeting, 421

CHAPTER 11 Cash Flow Estimation, 457 CHAPTER 12 Risk Topics and Real Options in Capital Budgeting, 484 CHAPTER 13 Cost of Capital, 514

Long-Term Financing Issues, 547 CHAPTER 14 Capital Structure and Leverage, 549 CHAPTER 15 Dividends, 599

Operations, 625 CHAPTER 16 The Management of Working Capital, 627 CHAPTER 17 Corporate Restructuring, 674

CHAPTER 18 International Finance, 711

Finance and Accounting, 7

The Importance of Cash Flow, 8The Language of Finance, 9

Financial Theory—The Relationship with Economics, 9

Forms of Business Organization and Their Financial Impact, 10

The Proprietorship Form, 10The Corporate Form, 11The Truth about Limited Liability, 13S-Type Corporations and Limited Liability Companies, 14

The Goals of Management, 14

INSIGHTS: The Limited Liability Company (LLC): An Alternative

to the S-Type Corporation, 15

Stakeholders and Conflicts of Interest, 16Conflicts of Interest—An Illustration, 16

Management—A Privileged Stakeholder Group, 16

The Agency Problem, 17

INSIGHTS: Ethics and Ethical Investing, 18

Creditors versus Stockholders—A Financially Important Conflict of Interest, 18

Securities Analysis and Thomson ONE—Business School Edition, 20

FINANCIAL STATEMENTS, AND TAXES, 24

The Tax Environment, 40

Taxing Authorities and Tax Bases, 40Income Taxes—The Total Effective Tax Rate, 41Progressive Tax Systems, Marginal and Average Rates, 42Capital Gains and Losses, 43

Income Tax Calculations, 44

Personal Taxes, 44Corporate Taxes, 48

INSIGHTS: The Other Purpose of the Tax System, 49

Questions, 52 Problems, 53 Internet Problem, 60 Computer Problems, 61

Financial Information—Where Does It Come From, Who Uses It, and What Are We Looking For?, 63

Users of Financial Information, 64Sources of Financial Information, 64

INSIGHTS: The Devil Is in the Details , 67

The Orientation of Financial Analysis, 67

INSIGHTS: The Ethics of Presenting Financial Information, 68

The Statement of Cash Flows, 70

How the Statement of Cash Flows Works—Preliminary Examples, 70

Business Cash Flows, 73Constructing the Statement of Cash Flows, 75Free Cash Flows, 79

Ratio Analysis, 80

Comparisons, 80Common Size Statements, 81Ratios, 82

Liquidity Ratios, 83Asset Management Ratios, 84Debt Management Ratios, 87Profitability Ratios, 89

Contents vii

Market Value Ratios, 90

Du Pont Equations, 92

INSIGHTS: Concepts in Financial Analysis: MVA and EVA, 94

Using the Du Pont Equations, 96Sources of Comparative Information, 96Limitations and Weaknesses of Ratio Analysis, 97

Four Kinds of Business Plan, 120The Financial Plan as a Component of a Business Plan, 123

Making Financial Projections, 123

Planning for New and Existing Businesses, 124The General Approach, Assumptions, and the Debt/InterestProblem, 124

Plans with Simple Assumptions, 130Forecasting Cash Needs, 132The Percentage of Sales Method—A Formula Approach, 132

The Sustainable Growth Rate, 135Plans with More Complicated Assumptions, 136

A Comprehensive Example—A Complex Plan for an Existing Business, 139

Planning at the Department Level, 146The Cash Budget, 147

Management Issues in Financial Planning, 151

The Financial Plan as a Set of Goals, 151Risk in Financial Planning in General, 152

INSIGHTS: Judgment Calls and Ethics in Business Planning, 154

Financial Planning and Computers, 155

Questions, 155

Business Analysis, 157

Problems, 159

Internet Problem, 167

viii Contents

AND INTEREST, 168

The Financial System, 168

Cash Flows Between the Sectors, 169Savings and Investment, 169

Financial Markets, 171

The Stock Market and Stock Exchanges, 174

Overview, 174Trading—The Role of Brokers, 174Exchanges, 175

Private, Public, and Listed Companies, and the Nasdaq Market, 176

Reading Stock Quotations, 179

INSIGHTS: Efficient Financial Markets, 181

Corporate Governance and the Sarbanes-Oxley Act of 2002, 181

The Agency Problem Revisited, 181Executive Compensation, 181The Moral Hazard of Stock-Based Compensation and Wealth, 183

The Link Between Stock Price and Reported Financial Performance, 184

The Responsibility of Auditors, Boards

of Directors, and Analysts, 185The Victims of Self-Interest at the Top, 186The Events of the 1990s, 187

The Provisions of the Sarbanes-Oxley Act, 187Auditors: Conditions in the Public Accounting Industry Before SOX, 188

The Sarbanes-Oxley Response to the Failure

of the Auditing Industry, 189Corporate Governance: Holding CEOs Accountable, 191The Sarbanes-Oxley Response to Claims of Ignorance

by Top Executives, 191Deception on Wall Street: Securities Analysts

at Major Brokerage Houses, 192

INSIGHTS: Independent Analysis–A Vanishing Alternative?, 193

Life After Sarbanes-Oxley, 194

Interest, 194

The Relationship Between Interest and the Stock Market, 194Interest and the Economy, 195

Debt Markets, 196

The Components of an Interest Rate, 198

Components of the Base Rate, 198Risk Premiums, 199

Contents ix

Putting the Pieces Together, 201Federal Government Securities, Risk-Free and Real Rates, 202Yield Curves—The Term Structure of Interest Rates, 205

INSIGHTS: The Implications of an Inverted Yield Curve, 206

Questions, 208

Business Analysis, 209

Problems, 211

Internet Problem, 214

Appendix 5A: Can There Be Interest without Money? The Desert Island, 214

Discounted Cash Flow and the Value of Securities, 219

CHAPTER 6 TIME VALUE OF MONEY, 221

a Formula, 231The Future Value of an Annuity—Solving Problems, 234Compound Interest and Non-Annual Compounding, 236The Present Value of an Annuity—Developing a Formula, 242The Present Value of an Annuity—Solving Problems, 243

INSIGHTS: The Lottery: Congratulations, You’re Rich—But Not as Rich

as You Thought, 245

The Annuity Due, 250Perpetuities, 253Multipart Problems, 256Uneven Streams and Imbedded Annuities, 259

Part 2

x Contents

Bond Valuation, 272

Bond Terminology and Practice, 272Bond Valuation—Basic Ideas, 273Determining the Price of a Bond, 274Maturity Risk Revisited, 280

Finding the Yield at a Given Price, 281Call Provisions, 283

INSIGHTS: Can a Bond Be a Bond Without Paying Interest?, 284

Institutional Characteristics of Bonds, 298

Registration, Transfer Agents, and Owners of Record, 298Kinds of Bonds, 298

Bond Ratings—Assessing Default Risk, 299

INSIGHTS: Even the Safest Companies Can Default on Bonds—The Perils of

Utility Deregulation in California, 301

Bond Indentures—Controlling Default Risk, 302

INSIGHTS: Ethical Debt Management, 303

Questions, 304 Business Analysis, 304 Problems, 305

Internet Problem, 309 Computer Problems, 309 Appendix 7A: Lease Financing, 310

Growth Models of Common Stock Valuation, 332

Developing Growth-Based Models, 332The Constant Growth Model, 335The Expected Return, 337

Two-Stage Growth, 337Practical Limitations of Pricing Models, 340

INSIGHTS: Reconciling Valuation Theory and Practice, 341

Contents xi

Some Institutional Characteristics of Common Stock, 342

Corporate Organization and Control, 342

INSIGHTS: Corporate Governance in Large Companies: The Role

Employee Stock Options, 359

Why Study Risk and Return? 369

The General Relationship Between Risk and Return, 370The Return on an Investment, 371

Risk—A Preliminary Definition, 372

Portfolio Theory, 373

Review of the Concept of a Random Variable, 373The Return on a Stock Investment

as a Random Variable, 378Risk Redefined as Variability, 379Risk Aversion, 382

Decomposing Risk—Systematic (Market)and Unsystematic (Business-Specific) Risk, 385Portfolios, 386

xii Contents

Diversification—How Portfolio Risk is Affected When Stocks are Added, 387

Measuring Market Risk—The Concept of Beta, 390

INSIGHTS: Is It Investing or Gambling?, 392 INSIGHTS: Just How Risky Is AT&T—Really? A Problem with Betas, 395

Using Beta—The Capital Asset Pricing Model (CAPM), 396

INSIGHTS: Beta in Practice, 405

The Validity and Acceptance of the CAPMand Its SML, 405

Questions, 406 Business Analysis, 407 Problems, 407

Internet Problem, 414 Computer Problems, 414 Developing Software, 415 Thomson ONE, 416

Business Investment Decisions—Capital Budgeting, 419

CHAPTER 10 CAPITAL BUDGETING, 421 Characteristics of Business Projects, 421

Project Types and Risk, 421Stand-Alone and Mutually Exclusive Projects, 422Project Cash Flows, 422

The Cost of Capital, 423

Capital Budgeting Techniques, 424

Payback Period, 424Net Present Value (NPV), 426Internal Rate of Return (IRR), 430Comparing IRR and NPV, 435NPV and IRR Solutions Using Financial Calculators and Spreadsheets, 436

Projects with a Single Outflow and Regular Inflows, 438Profitability Index (PI), 439

Comparing Projects with Unequal Lives, 440

INSIGHTS: Which Methods Do Businesses Prefer?, 441

Capital Rationing, 444

Questions, 445 Business Analysis, 447 Problems, 448

Calculator Problems, 451 Internet Problem, 454 Computer Problems, 455

Part 3

Contents xiii

CHAPTER 11 CASH FLOW ESTIMATION, 457

Cash Flow Estimation, 457

Capital Budgeting Processes, 457

Project Cash Flows—An Overview and Some Specifics, 458

The General Approach to Cash Flow Estimation, 458

A Few Specific Issues, 459

Estimating New Venture Cash Flows, 462

Terminal Values, 466Accuracy and Estimates, 467MACRS—A Note on Depreciation, 468

Estimating Cash Flows for Replacement Projects, 469

INSIGHTS: Ethics in Cash Flow Estimation, 473

Risk in Capital Budgeting—General Considerations, 484

Cash Flows as Random Variables, 484The Importance of Risk in Capital Budgeting, 485

Incorporating Risk into Capital Budgeting—Numerical and

Computer Methods, 487

Scenario/Sensitivity Analysis, 487Computer (Monte Carlo) Simulation, 489Decision Tree Analysis, 490

Real Options, 495

Real Options in Capital Budgeting, 495Valuing Real Options, 498

INSIGHTS: Volatile Energy Prices and Real Options Thinking Can Lead

to Big Profits on Inefficient Facilities, 499

Designing Real Options into Projects, 499

Incorporating Risk into Capital Budgeting—The Theoretical Approach

and Risk-Adjusted Rates of Return, 500

Estimating Risk-Adjusted Rates Using CAPM, 502Problems with the Theoretical Approach—Finding the Right Beta and Concerns about the Appropriate Risk Definition, 504

Questions, 506

Business Analysis, 507

Problems, 508

CHAPTER 13 COST OF CAPITAL, 514

The Purpose of the Cost of Capital, 514

xiv Contents

Cost of Capital Concepts, 515

Capital Components, 515Capital Structure, 515

INSIGHTS: The Cost of Capital—Intuitively, 516

Returns on Investments and the Costs

of Capital Components, 516The Weighted Average Calculation—The WACC, 517Capital Structure and Cost—Book versus Market Value, 518

Calculating the WACC, 520

Developing Market-Value–Based Capital Structures, 520Calculating Component Costs of Capital, 521

Putting the Weights and Costs Together, 528

The Marginal Cost of Capital (MCC), 528

The Break in MCC When Retained Earnings Run Out, 528The MCC Schedule, 529

The Cost of Capital—A Comprehensive Example, 531

A Potential Mistake—Handling Separately Funded Projects, 536

INSIGHTS: Revisiting EVA, 537

Questions, 538 Business Analysis, 539 Problems, 540

Internet Problem, 546

Long-Term Financing Issues, 547

CHAPTER 14 CAPITAL STRUCTURE AND LEVERAGE, 549 Background, 549

The Central Issue, 550Risk in the Context of Leverage, 550Leverage and Risk—Two Kinds of Each, 551Our Approach to Leverage, 552

Financial Leverage, 552

The Effect of Financial Leverage, 552Financial Leverage and Financial Risk, 558Putting the Ideas Together—The Effect on Stock Price, 559

INSIGHTS: AOL Time Warner (Time Warner INC.): The Perils of Leverage, 561

The Degree of Financial Leverage (DFL)—A Measurement, 562EBIT–EPS Analysis, 565

Operating Leverage, 567

Terminology and Definitions, 567Breakeven Analysis, 568

Breakeven Diagrams, 568The Effect of Operating Leverage, 571The Degree of Operating Leverage (DOL)—A Measurement, 574

Part 4

Contents xv

Comparing Operating and Financial Leverage, 575The Compounding Effect of Operating

and Financial Leverage, 576

Capital Structure Theory, 577

Background—The Value of the Firm, 578

INSIGHTS: Leverage and Business Strategy, 578

The Early Theory by Modigliani and Miller, 581Relaxing the Assumptions—More Insights, 584

An Insight into Mergers and Acquisitions, 588

Practical Considerations, 607

Legal and Contractual Restrictions on Dividends, 607

INSIGHTS: The Painful Decision to Cut Dividends, 608

Dividend Policy, 609The Mechanics of Dividend Payments, 610Stock Splits and Dividends, 611

CHAPTER 16 THE MANAGEMENT OF WORKING CAPITAL, 627

Working Capital Basics, 627

Working Capital, Funding Requirements,and the Current Accounts, 628

Part 5

xvi Contents

INSIGHTS: Going Broke Profitably, 628

The Objective of Working Capital Management, 630Operations—The Cash Conversion Cycle, 630Permanent and Temporary Working Capital, 632Financing Net Working Capital, 632

Working Capital Policy, 635

Sources of Short-Term Financing, 636

Spontaneous Financing, 636Unsecured Bank Loans, 638Revolving Credit Agreement, 638Commercial Paper, 640

Short-Term Credit Secured by Current Assets, 641

Cash Management, 645

Definitions and Objectives, 645Marketable Securities, 646Check Disbursement and Collection Procedures, 647Accelerating Cash Receipts, 648

INSIGHTS: Technology Is Speeding Up the Check Clearing Process: “Check 21,”

the Check Clearing for the 21st Century Act, 649

Managing Cash Outflow, 651Evaluating the Cost of Cash Management Services, 651

INSIGHTS: Ethical Cash Management, 652

Managing Accounts Receivable, 653

Objectives and Policy, 653Determinants of the Receivables Balance, 653

INSIGHTS: A Practical Management Warning, 655 INSIGHTS: How Lafarge’s Western Region Controls Receivables—Sharing

Responsibility for Collections with Sales, 657

Inventory Management, 657

Who Is Responsible for Inventories?, 658The Benefits and Costs of Carrying Inventory, 658Inventory Control and Management, 659

The Economic Order Quantity (EOQ) Model, 660Safety Stocks, Reorder Points, and Lead Times, 662Tracking Inventories—The ABC System, 664Just In Time (JIT) Inventory Systems, 664

Questions, 665 Business Analysis, 667 Problems, 668

Internet Problem, 673 CHAPTER 17 CORPORATE RESTRUCTURING, 674 Mergers and Acquisitions, 674

Basic Definitions, Terminology, and Procedure, 674

Contents xvii

The Antitrust Laws, 678The Reasons Behind Mergers, 679Holding Companies, 681

The History of Merger Activity in the United States, 681Merger Analysis and the Price Premium, 685

INSIGHTS: How a Trendy Soft Drink Gave Cereal Giant Quaker

Oats a $1.4 Billion Case of Indigestion, 692

Defensive Tactics, 693

Other Kinds of Takeovers—LBOs and Proxy Fights, 695

Leveraged Buyouts (LBOs), 695Proxy Fights, 696

Divestitures, 696

The Reasons for Divestitures, 696Methods of Divesting Operations, 696

Bankruptcy and the Reorganization of Failed Businesses, 697

Failure and Insolvency, 697Bankruptcy—Concept and Objectives, 698Bankruptcy Procedures—Reorganization, Restructuring, Liquidation, 698

INSIGHTS: Has Bankruptcy Been Too Easy For Too Long?

The Bankruptcy Reform Act of 2005, 701

of Exchange Rate Movement, 716Governments and the International Monetary System, 719

International Capital Markets, 721

The Eurodollar Market, 722The International Bond Market, 722

Political Risk, 723

Transaction and Translation Risks, 723

INSIGHTS: The Foreign Corrupt Practices Act— A Legal/Ethical

Dilemma for U.S Companies, 724

Questions, 730 Business Analysis, 731 Problems, 732

Internet Problem, 734 APPENDIX A FINANCIAL TABLES, 738 Glossary, 746

Index, 756

William R Lasher • Nichols College, Professor of Finance • Former Chief Financial Officer

Dear Colleague,

I’d like to introduce myself and my book, Practical Financial Management (PFM), to you in this short note In particular, I’d

like to explain why I wrote the text and why I’m confident that you and your students will be more than pleased with the learning

experience they’ll take from it

I started teaching finance in the evening as an adjunct professor about thirty five years ago In the daytime I climbed the corporate

ladder in finance becoming the CFO of a fairly substantial company Eventually my love of teaching and writing led me to change

careers and become a full time educator and author, which is what I’m doing today

The point of that little story is to explain that I came to the textbook writing business with an unusual perspective I’m a fully

qualified academic, but I’ve also spent many years as a financial executive And in that role I practiced the ideas and techniques

that finance textbooks are all about

From the beginning, I had two major problems with other finance texts First, they were very difficult for students to understand

I always felt there had to be a way to explain difficult concepts so that average students could absorb them without unreasonable

effort It turns out I was right, and the method is embodied in PFM It involves a deliberate, step by step approach to quantitative

material, and explaining every new idea begining with first principles while assuming students know nothing about each subject

when they start reading The approach really works, and it’s done without shortchanging content We get feedback from students

and instructors all the time to the effect that anyone can learn finance from this text The most frequent student comment is that

reading PFM “is like the author is right there talking to me.”

Second, other textbooks don’t talk about many of the issues that take up most of financial executives’ time These are the human

conflicts that come up in all businesses and can tear a company apart My two favorite examples involve receivables and capital

budgeting With respect to the former there’s often a battle between sales and finance over credit policy Finance doesn’t want to

get stuck with bad debts, while it seems commission driven sales people try to extend credit to even the shakiest customers This

issue can sink a financial executive if he or she doesn’t insist that sales people share responsibility for collections

The second example comes from the fact that capital budgeting projects are almost always proposed by people or departments that

will benefit if proposals are approved But those are the same folks who work up the revenue and cost projections used in NPV

and IRR analysis That means cash flow estimates in capital budgeting are consistently very favorably biased Unfortunately the

finance department usually faces an uphill battle in keeping those inputs reasonable

PFM talks about such issues in depth, because I lived with them, day in and day out, for years The insights I’m sharing are

high-lighted throughout the book with a “from the CFO” logo in the margins

In short, PFM has two features I’m sure you’ll find invaluable: readability and practical relevance We’ve tried to convey the essence

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If you’re a new adopter, I’m sure you won’t be disappointed If you’re a returning user, welcome back; I’m confident you’ll enjoy

the changes we’ve made in creating the fifth edition

HELPING YOUR STUDENTS NAVIGATE ANY CHALLENGES THEY FIND UPSTREAM

With its clear, concise, and

real-world treatment of key

financial management

topics, Practical Financial

Management guides

stu-dents on the stream to

suc-cess Author and former CFO

William R Lasher crafted

this text to match the

back-ground knowledge and

abili-ties of typical business

students—many of whom

have little experience with

financial concepts

From cash flow to operating

issues, Practical Financial

Management provides

rele-vant and accessible

discus-sion of the key topics

students will encounter on

their voyage through

finan-cial management Lasher

presents the material in a

way that lets students “sit

in” on realistic descriptions

of the conflicts that financial

managers face every day—

including the hidden

agen-das and biases that

decision-makers often bring

to the analysis of financial

proposals

APPLIED

From the CFO

Based on his experience

as a CFO, Lasher includesconcise comments thatdeal with finance in actualpractice and offer tipsgrounded in real-world

experience Insights From the CFO are found

throughout the text, eachidentified by a logo in thepage margin and italicizedprint

Thought-provoking INSIGHTS

These popular boxed features cover Practical Finance, Ethics, and Real Applications Practical Finance boxes provide analysis and

understanding of financial principles as applied in practice alongside

textual presentations of the underlying concepts Ethics features

delve into the moral dilemmas faced by financial managers every day

Real Applications provide real-world examples that show how

chap-ter subject matchap-ter impacts large,well-known companies

ACCESSIBLE

Rely on Lasher to steer your students through the real challenges and

con-flicts that financial managers face every day!

Thomson ONE—Business

School Edition Exercises

Students can use the Thomson ONE

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Thomson ONE problems Thomson

ONE combines a full range of

funda-mental financials, earnings

esti-mates, and market data for hundreds

of real-world companies Access to

Thomson ONE—Business School

Edition is provided by registering a

unique serial number that comes

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Business Analysis Exercises

Placed at the end of each chapter,

Business Analysis scenarios are

criti-cal thinking mini-cases that put

stu-dents in delicate organizational

situations and ask them to develop

reasonable solutions

Internet Notes and Exercises

Internet addresses and descriptions

are included in the margin material to

direct students to websites that

expand upon the material being

pre-sented Internet exercises are also

included in end-of-chapter material

Step-by-step Examples

Numerous worked-out ples walk students throughthe processes, step-by-step.This makes PracticalFinancial Management aresource that students canuse by themselves as well asunder supervision

exam-Clarity of Presentation

Every new topic begins with a presentation of the heart of a businessproblem or issue, starting from scratch and assuming students knownothing about the topic With this approach, students avoid confu-sion and know exactly where they are going and why

Practical Mathematics

Wherever math is involved,Lasher explains the physicaland business relationshipsbetween variables beforedeveloping or using equa-tions By discussing whateach aspect of a relationshipmeans as it is put together,Lasher gives the equationssubstance and meaning tomake students more com-fortable in quantitative areas

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Test Bank0-324-64886-3Edited by William R Lasher and updated by Tom Arnold of the University of Richmond, all ques-tions in the Test Bank are consistent with the text’s style and notation as well as clear, read-able, and appropriate for students’ abilities Contains over 2,500 insightful questionscategorized by topic area Question types include multiple choice, true/false, fill-in, essays, andproblems

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Six-Month Access Card: 0-324-23596-8Give students integrated access to Thomson Financial content for financial analysis! ThomsonONE combines a full range of fundamental financials, earnings estimates, and market data forhundreds of real-world companies This is an academic version of the same tools used by WallStreet Analysts every day Many text chapters include Thomson ONE Business School Editionexercises that direct students on using the academic online database Access to Thomson ONEBusiness School Edition is provided by registering a unique serial number that comes witheach new book

Book Companion Websitewww.thomsonedu.com/finance/lasher

When you adopt Practical Financial Management, you and your students haveaccess to a rich array of teaching and learning resources that you won’t find any-where else This outstanding site features access to student resources, instruc-tor resources, Internet updates and links, spreadsheet software, PowerPoint®lecture slides, and other useful components Students can go directly to this

Web site to link to the Internet addresses in the text margins and to work the end-of-chapterInternet exercises

The fifth edition of Practical Financial Management is the latest milestone in a 35-year

journey in education that began when I was a corporate executive teaching finance as

an adjunct professor

Not long after starting down that road I realized that I might be able to improve onthe approach taken by most finance texts It was true then, and it’s still true today,

that most finance texts are harder for students to understand than they should be

The issue is relatively unique to the field No other business discipline seems to havefinance’s reputation for unfathomable reading material

I eventually came to the conclusion that the problem lies in the fact that textbookpresentations are inconsistent with the background knowledge and abilities of typicalbusiness students That isn’t to say that the texts are poorly done By and large,

finance texts are good books They’re logical, well written, and comprehensive But

they’re consistently off target in several key areas with respect to the students who

read them

The first problem has to do with student background Texts tend to introduce

topics using a voice that assumes the student already has some grounding in the area

to be studied Even bright students are confused and intimidated by this practice,

because most don’t know anything about the subject area when they start a chapter

The second issue relates to quantitative material A great deal of finance is

grounded in math and statistics, so students have to take prerequisite courses in thoseareas But most business students aren’t really comfortable with quantitative methods,even after they’ve had the courses This leads to the biggest pedagogical problem wehave Textbooks assume business students are better at math than they are As a

result, most readers can’t follow textbook presentations of quantitative material out an inordinate amount of time and study

with-Finally, there is a troubling lack of practicality in much of this literature For ple, texts present techniques like NPV and IRR implying hair-splitting accuracy thatdoesn’t exist in the real world, where results often depend on biased and uncertain

exam-inputs Textbooks are also silent on the behavioral problems that financial managersdeal with every day For example, the conflict between sales and finance over receiv-ables can tear a company apart, but it is rarely mentioned in textbooks

The result of all this has been that finance professors don’t get much help from

textbooks in teaching introductory courses We develop classroom approaches that getthe ideas across, but spend a great deal of time explaining the text rather than using it

to support our teaching

Over a period of years, I developed ways around these problems that eventually

evolved into Practical Financial Management I began by writing expositions on

sub-jects that gave students the most trouble, starting with time value and portfolio

theory Those explanations really worked! Time value is a good example Students

have difficulties even though they’ve generally seen it before After reading my rial, students would come in saying, “I never really understood time value when I had

mate-it in accounting and math, but now I do!” As you can imagine, that felt pretty good.Fifteen years later, after serving in a number of corporate financial positions includ-ing chief financial officer (CFO), I changed careers, becoming a full-time educator in

order to pursue my first loves: teaching and writing One of the results is Practical

Financial Management (PFM), now in its fifth edition PFM is unique because of its

xxv

Next, wherever math is involved we explain the physical and business ships between variables before developing or using equations We discuss what eachaspect of a relationship means as we put it together That gives the equations sub-stance and meaning to students who are less than comfortable in quantitative areas.See the development of IRR in Chapter 10 as an example (pages 430–431).

relation-Then, when we do use math or complex procedures, we carefully explain whatwe’re doing step by step We assume students have the basic tools of algebra oraccounting or statistics, but we don’t assume they know that material well This isanother crucial point Most students aren’t really skilled in those areas But because

our systematic presentation recognizes that, students don’t get lost or stuck PFM is a

resource students can use by themselves as well as under supervision They can readwhole chapters on their own and come to class better prepared than ever before Look

at the first pages in the development of the time value of money in Chapter 6 as anexample (pages 223–224) Also see the development of the statement of cash flows inChapter 3 for the same idea in the context of difficult accounting material ratherthan math (pages 75–79)

Finally, I’ve drawn on my years as a financial executive and CFO to present someinsights into how things really work You’ll find these explanations throughout thebook, identified by a “From the CFO” icon in the margin A prime example dealswith the problems associated with estimating cash flows for capital budgeting projects,which is found in Chapter 11 (see Example 11.2, pages 469–472—the people whopropose capital projects are usually biased toward acceptance)

PFM’s end-of-chapter Business Analysis exercises are another important practical

feature They are mini-cases designed to open students’ eyes to the realities of ing financial principles in actual business situations The questions at the end ofChapter 11 on cash flow estimation are good examples (pages 473–475)

apply-Throughout, I’ve tried to write this book in a way that’s easy to read, enjoyable,and unintimidating The word that sums that up is “accessible.” I think I’ve been suc-cessful, because reviewers have been unanimous in their praise of the work’s conversa-tional style and easy readability

Thank you for using Practical Financial Management I’m absolutely sure you and

your students will be pleased with the learning experience they’ll have as a result.CHANGES TO THIS EDITION

We’ve made a number of exciting changes in the fifth edition that will please sors and students alike The following is a brief summary

profes-Reorganization Emphasizing Financial Planning

We’ve reorganized the text by moving the financial planning chapter forward into PartOne from its earlier position near the end of the book There’s a twofold rationale forthis move First, treating planning in the fundamentals section is meant to emphasize

Preface xxvii

the ever increasing importance of planning and forecasting in today’s business

envi-ronment Indeed it’s very likely that young professionals, whether in finance or

another department, will be involved in a planning exercise within their first year inbusiness This implies that coming into the workplace with a grounding in the phi-

losophy behind planning as well as an understanding of its real world techniques will

be invaluable to their early career development In other words, we feel that an sure to planning is likely to make students better managers and executives sooner

expo-Hence we’ve moved the planning chapter to the forefront of the text where it’s morelikely to be included in a one semester fundamentals course, which may be the only

exposure to finance that non-majors get

Second, the new placement makes pedagogical sense Planning is now covered inChapter 4, immediately followng Chapter 3’s treatment of ratio analyis and Chapter2’s review of accounting and financial statements Since planning involves projectingfinancial statements and uses ratios as a forecasting tool, it’s a good idea to study thesubject while those concepts are fresh in students’ minds

Having said that, we recognize that some professors will still prefer to defer or omitcoverage of financial planning That’s not a problem because the chapter can be

skipped without loss of continuity

Comprehensive Treatment of Executive Ethics

and the Sarbanes-Oxley Act

In the early 2000s the world discovered that an unprecedented fraud had been trated on the investing community by a significant number of corporate executives inthe 1990s Exposure of the wrongdoing resulted in investment losses in the hundreds

perpe-of billions if not trillions perpe-of dollars The federal government responded with the

Sarbanes-Oxley Act (SOX), legislation that forever changed the governance of publiccorporations and the public accounting industry Surprisingly, corporate finance textshave been slow to include discussions of the Sarbanes-Oxley Act, its roots, or its

implications

We’ve addressed that omission in the fifth edition by adding a section on SOX toour coverage of the financial system in Chapter 5 We begin by explaining how stockbased incentives create a moral hazard for executives who can influence financial

reporting From there we describe how the financial and auditing systems were posed to protect investors and how they failed to do so Only after that foundation islaid, do we get into the provisions of the Act, what it’s designed to do, and its impact

sup-on the business and financial world The result will be students who understand whatwent wrong, why it happened, how the legislative fix is working, and how it has

changed the financial world

Issues in International Finance—Globalization

The explosion in international business going on today is part of the globalization

phenomenon, which has created a number of high profile financial and economic

issues These include free trade (versus protectionism), outsourcing, legal and illegal

labor migration, and the inconvertibility of China’s currency Here again finance

texts have been slow to treat these developing issues although they profoundly affectthe international business and financial environment

The fifth edition of Practical Financial Management adds a discussion of

globaliza-tion in the internaglobaliza-tional finance chapter Once again we begin with the basics, oping the idea of comparative advantage and showing how it leads to a conflict

devel-between free trade and protectionist policies With that background we discuss the

current globalization trend and outline both its positive and negative implications

xxviii Preface

The treatment then focuses on spcific problem areas such as job and labor migration,immigration, outsourcing, and the balance of trade with China In summary, theadded section quickly brings students into the current world of international businessand trade relations

Additional End-of-Chapter Problems

Several new problems, developed by the author and Dianne Morrison (University ofWisconsin—La Crosse) have been added at the end of every chapter The new prob-lems vary in difficulty and have been dispersed among the existing problems

New INSIGHTS Boxes

PFM’s successful series of thought-provoking INSIGHTS boxes have been updated

and enhanced with the addition of several new articles The Ethics series highlightsmoral or ethical dilemmas faced by financial executives, the Practical Finance seriesapplies chapter concepts to real and hypothetical problems, and Real Applicationsfocuses on applications involving large, well-known companies

CONTINUING UNIQUE AND IMPORTANT FEATURESThe following special features have been retained from earlier editions

From the CFO

This feature highlights material that’s based on the author’s experience as a CFO.These comments deal with finance in actual practice and offer tips and insightsgrounded in real-world experience “From the CFO” material appears throughout thetext and is identified by a logo in the margin and italicized print

Margin Notes

PFM’s summarizing margin notes are particularly complete and thorough They

pro-vide students with a convenient summary/outline of the textual material rather thanjust a list of key words

Internet Notes and Exercises

Internet addresses and descriptions are included in the margins to direct students toWeb sites that expand upon the material being presented Internet exercises are alsoincluded in end-of-chapter material

INSIGHTS: Practical Finance

PFM’s Practical Finance boxes provide analysis and understanding of financial

princi-ples as applied in practice alongside textual presentations of the underlying concepts

INSIGHTS: Ethics

Our ethics features delve into the moral dilemmas faced by financial managers everyday The issues are presented alongside relevant subject matter and focus on the ethicalproblems constantly in today’s news

INSIGHTS: Real Applications

The Real Applications features provide real world examples that show how chaptersubject matter impacts large, well-known companies

Preface xxix

BUSINESS ANALYSIS Exercises

A thought provoking series of exercises has been placed at the end of each chapter

Basically qualitative in nature, Business Analysis scenarios are mini-cases that place

students in delicate organizational or political situations and ask them to develop sonable solutions

rea-SUPPLEMENTS

Practical Financial Management comes with a full set of supplements, which are

avail-able in print and/or on the text Web site, or by online purchase

Thomson ONE—Business School Edition: Use the Thomson ONE academic

online database to work chapter Thomson ONE problems Thomson ONE combines

a full range of fundamental financials, earnings estimates, and market data for

hun-dreds of real-world companies This is an academic version of the same tools used byWall Street analysts every day Access to Thomson ONE—Business School Edition isprovided by registering a unique serial number that comes with each new book

ThomsonNOW: ThomsonNOW provides students with a robust set of additional

online learning tools, and is available in both Blackboard and WebCT Here is a tourthrough some of the study support features found in ThomsonNOW for Lasher:

• Personalized Learning Path: Each chapter includes a personalized learning path

that allows students to take a pre-test to assess their prior knowledge of the materialand then based on the results of that pre-test, establishes a Learning Path that focusesthe student’s studies on the material where he or she needs the most work The studymaterials presented here include the appropriate section of the ebook, video elements,and other multimedia learning objects A post-test is then available to assess a student’sprogress after using the Personalized Learning Path

• Ebook: Every ThomsonNow product includes a complete ebook version of the

textbook for easy electronic access

• Homework: ThomsonNow includes end-of-chapter problems that instructors can

assign as homework or include in electronically graded quizzes and tests

• Test Bank: The complete Test Bank for this product is also included so that

instructors can create tests and exams directly in ThomsonNow and assign them to

students for automatic grading and results

Product Support Web Site PFM’s Web site at http://thomsonedu.com/finance/

lasher contains student resources, instructor resources, Internet updates and links,

spreadsheet software, and other useful features Students can go directly to the text

Web site to link to the Internet addresses in the text margins and to work the chapter Internet exercises The Web site also provides instructors and students with

end-of-access to unique features such as “NewsWire: Finance in the News,” “NewsEdge,”

“Finance Interactive,” as well as customer service information and links to

book-related Web sites Learn about valuable products and services to help with your

finance studies, contact the finance editors, and more

Spreadsheet Software PFM contains two types of computer problems in the

end-of-chapter material Some problems use spreadsheet templates, while others

require students to create their own spreadsheet software The templates, developed

xxx Preface

by the author and Leonard W Gajewski of Nichols College, are available on the textWeb site and through ThomsonNOW to both students and instructors

PowerPoint Lecture Slides PowerPoint slides, revised for this edition by the

author and Patricia M Bernson of County College of Morris, are available to tors These slides are designed for classroom presentation, with most illustrative exam-ples summarized, providing a useful lecture tool

instruc-Instructor’s Manual The instruc-Instructor’s Manual is written and maintained by the

text’s author, with the help of Dianne Morrison of the University of Wisconsin,LaCrosse It contains chapter-by-chapter focus statements, pedagogical tips, andteaching objectives All of the discussion questions are answered in detail, and solu-tions to the problems are fully worked out The Instructor’s Manual is available inbook form and on the instructor’s Web site, where it is password-protected for instruc-tor use only

Test Bank The text author personally edits the test bank, ensuring that all

ques-tions are consistent with the text’s style and notation and that all are clear, readable,and appropriate for students’ abilities This edition is revised by Tom Arnold of theUniversity of Richmond and the text author, and contains over 2,500 insightful ques-tions categorized by topic area The questions include multiple choice, true/false, fill-

in, essays, and problems

ExamView The ExamView computerized testing program contains all of the

ques-tions in the printed test bank ExamView is easy-to-use test creation software that’scompatible with Microsoft Windows In making up tests, instructors can edit ques-tions, add their own questions or instructions, and print out answer sheets Questionscan be selected by number, randomly or through an on-screen preview Instructors canalso create and administer quizzes online, using the Internet, local-area networks, orwide-area networks

Cases The Finance Online Case Library includes more than 100 cases from which

instructors can create their own course-specific casebook Visit http://www.textchoice.

com or contact your Thomson Learning sales representative for details.

ACKNOWLEDGMENTS

We can’t say enough in praise of the following reviewers who participated in the ing of each edition of this book They provided encouragement, criticism, ideas, andenthusiasm, all at the right times

writ-Ibrahim Affaneh Indiana University of PennsylvaniaBrian L Belt University of Missouri—Kansas CityOmar M Benkato Ball State University

Michael A Bento Owens Community College

Gilbert W Bickum Eastern Kentucky UniversityEric Blazer Millersville UniversityGordon R Bonner University of Delaware

G Michael Boyd Stetson University

Preface xxxi

Haiyang Chen Youngstown State University

Faye Austin Cook University of North Carolina at Charlotte

Louann Hofheins Cummings Siena Heights University

Maryanne P Cunningham University of Rhode Island

Dennis Debrecht Carroll College

Gary R Dokes University of San Diego

R Stephen Elliott Northwestern State University

Soga Ewedemi Clarion University of Pennsylvania

E Bruce Fredrikson Syracuse University

Phillip Fuller Jackson State University

Robert J Hartwig Worcester State College

Delvin D Hawley University of Mississippi

Marianne Hite University of Colorado at Denver

Norbert Jerina Cuyahoga Community College

Jenna J Johannpeter Belleville Area Community College

Frederick J Kelly Roger Williams University

Robert T Kleiman Oakland University

Morris Knapp Miami-Dade Community College

Howard Langer California State University—Northridge

S Brooks Marshall James Madison University

Lee McClain Western Washington University

Stuart Michelson University of Central Florida

Cynthia Miglietti Bowling Green State University

Dianne R Morrison University of Wisconsin, LaCrosse

Allen D Morton Western Connecticut State University

Kenneth F O’Brien Farmingdale State University of New YorkJames M O’Donnell Huntington College

Gregory J Petrakis University of Missouri—Kansas City

Armand Picou University of Central Arkansas

Dennis Proffitt Grand Canyon University

Michael R Rouse University of Massachusetts—Lowell

Andrew Saporoschenko Clemson University

Frederick P Schadler East Carolina University

David Schalow California State University, San BernadinoTimothy S Scheppa Concordia University

Patricia Setlick William Rainey Harper College

Elliott P Smith Boston College

Edward J Stendardi St John Fisher College

Charles W Strang Western New Mexico State University

Waymond D Summers Oklahoma City Community College

William K Templeton Butler University

Clifford F Thies Shenandoah University

Bijesh Tolia Chicago State University

Sanjay B Varshney SUNY Institute of Technology at Utica/Rome

xxxii Preface

Richard Yanow Massachusetts College of Liberal ArtsRassoul Yazdipour California State University, FresnoShirley Zaragoza Borough of Manhattan Community CollegeSpecial thanks go to Dianne Morrison (University of Wisconsin—La Crosse) whotirelessly and carefully checked all problems and solutions to help ensure accuracy,Raj K Kohli (Indiana University, South Bend), who updated the tax problems for thebook, and Tom Arnold (University of Richmond) and Mary Fox Luquette (University

of Louisiana, Lafayette), who both contributed greatly to the new content for theThomsonNOW product And finally, an extra-special thanks to Kathy Piniarski ofNichols College for her support through all five editions

In addition, I would like to extend my sincere appreciation to the members of theThomson South-Western team whose efforts resulted in this fifth edition and all of itssupplements: Mike Reynolds, my acquisitions editor, who provided encouragement andguidance; Susanna Smart, my developmental editor and long-time friend, whose ideasand tireless support through five editions have been an invaluable cornerstone of theoverall effort; Jason Krall, the marketing manager, whose enthusiastic contributions tothe promotion of the text have helped to make it the success it is today; Matt

McKinney, senior technology project editor, whose work on the technology products forthe text continues to improve the package with each edition; Bethany Casey, thedesigner who created the fresh and innovative appearance of the text; and PatrickCosgrove, my production editor, whose attention to detail resulted in this final product

William R LasherABOUT THE AUTHOR

Professor Lasher has a unique background that includes extensive experience as

an educator and as a corporate financial executive Prior to entering full-time demics, he worked for Texas Instruments, Harris Corporation, and the Pacific Telesisorganization During those years, he served as a corporate financial planner, a con-troller, and as a subsidiary CFO While working in industry he taught graduate andundergraduate finance and economics as an adjunct professor at the University ofDallas, the University of Texas at Dallas, and Golden Gate University in SanFrancisco He moved into education full time in 1988 when he joined the faculty atNichols College in Massachusetts

aca-Professor Lasher has a B.S and an M.B.A from Columbia University, received hisPh.D from Southern Methodist University, holds a J.D from the New EnglandSchool of Law, and has earned a Certified Public Accountant designation He has alsopublished books on business planning, franchising, and the strategic management ofsmall firms

Financial Statements, and Taxes

and Interest

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F OUNDATIONS

AN OVERVIEW OF FINANCE

Finance is the art and science of handling money In the modern world virtually every organization,public and private, runs on money That includes families, businesses, governments, and nonprofitenterprises Money touches everything we do And finance, the management of money, is behind mosteverything we see each day We don’t physically observe the financing behind a building or a new car

or a house, but it’s there, and without it most of the things we do see wouldn’t exist That’s becausewithout money to pay for resources and a financial system to make trading possible, no one couldorganize more than a few people to work together at one time

Our study of finance will be broadly divided into two areas: (1) investments and financial marketsand (2) the financial management of companies.1These are separate but related A financial systeminvolves flows of money and paper between the two

To begin our study of finance, we need a few basic terms and ideas Let’s master these before goingany further

FINANCIAL ASSETS

A real asset is an object or thing, such as a car, a house, a factory, or a piece of machinery Real assets

have value because they provide service of some kind, such as transportation, shelter, or the ability toproduce something

An Overview of Finance

Financial AssetsFinancial MarketsRaising MoneyFinancial ManagementThe Price of Securities—A Link Between the Firm and the Market

Finance and Accounting

The Importance of Cash FlowThe Language of Finance

Financial Theory—The Relationship with Economics

Forms of Business Organization and Their Financial Impact

The Proprietorship FormThe Corporate Form

The Truth about Limited LiabilityS-Type Corporations and LimitedLiability Companies

The Goals of Management

Stakeholders and Conflicts of Interest

Conflicts of Interest—An Illustration

Management—A Privileged Stakeholder Group

The Agency Problem

Creditors versus Stockholders—A Financially Important Conflict of Interest

4 Part 1 Introduction to Financial Management

Financial assets, on the other hand, are legal documents, pieces of paper Theirvalue comes from the fact that they give their owners claim to certain future cashflows Most financial assets are either stocks or bonds, and their claim to future income

is based on ownership or debt, respectively

Stockownership means that the holder of a share owns a piece of the companythat issued the stock As a part owner, he or she is entitled to a share of the firm’sprofits, which may be paid out in dividends or retained to enhance prospects forgrowth The shareholder generally expects to sell the share at some time in the futureand will then receive the proceeds of that sale in cash Thus, the owner of a stock cer-tificate can look for two sources of cash in the future: dividends and the eventual sell-ing price of the share

A bond signifies a debt relationship When a person buys a bond, he or she is

actu-ally lending money to the firm issuing the bond The terminology seems strange—

“buying a bond” meaning “lending money.” Nevertheless, a bondholder is actually alender and as such is entitled to interest on the amount lent and the repayment ofprincipal at the end of the loan period

Companies issue financial assets to raise money They generally use that money tobuy real assets that are used in running their businesses

Financial assets are purchased by people or other companies to earn income withfunds they don’t currently need Buying such an asset is similar to opening a savingsaccount and receiving interest on the money you’ve put in the bank In fact, a savingsaccount is another kind of financial asset Another name for a financial asset like a

stock or a bond is a security.2A person or organization buying a financial asset is said

to be investing in that asset, and we generally call that buyer an investor.

Investments in financial assets can be made directly by buying securities or

indi-rectly by buying shares in a mutual fund A mutual fund pools the contributions of

many investors and employs a professional manager to select securities that match aparticular set of investment goals

FINANCIAL MARKETSStocks and bonds as well as certain other kinds of financial assets are issued by com-

panies and purchased by investors in financial markets A financial market isn’t exactly

a place; rather, it’s a framework or organization in which people can buy and sell rities in accordance with well-defined rules and regulations The best known financial

secu-market is the stock secu-market It is centered in several places around the country, called

stock exchanges The largest exchange is the New York Stock Exchange, oftenreferred to as the NYSE

To participate in the market, you don’t have to go to an exchange You simply

establish a relationship with a stockbroker in your area and communicate with him or

her by phone A stockbroker is a person who is licensed to help investors buy and sell

securities for a commission Local brokers are connected to the various exchanges tronically The stock market is really the entire network of brokers and exchanges allconnected together Bond markets for trading debt securities operate similarly

elec-In summary, financial markets are “places” where investors buy financial assetsfrom companies that issue them Investors also buy and sell the same financial assetsbetween themselves in the same financial markets In fact, the vast majority of trans-actions are between investors That’s because a security is issued by a company onlyonce, but it may be traded among investors many times thereafter

Besides stock quotes

and other data and

Chapter 1 Foundations 5

In practice, the term “market” describes the combined actions of investors actingwithin the marketplace just described For example, someone might say that themarket has placed a price of $100 on a share of IBM That would mean the goingprice among investors buying and selling the stock of the IBM corporation within thestructure of the stock market is $100

Figure 1.1 is a schematic representation of the interaction between companies andthe market

The field of investments involves making decisions about buying stocks and bonds.Decisions about how to raise money and what to do with it are part of the financialmanagement of a firm These decisions are made on the two sides of Figure 1.1, whichrepresent the two areas in which our study will focus

Now let’s consider the word “finance” itself Its use can be a little confusing It’s anoun, as in “the field of finance.” It’s a verb, as in “to finance something.” And it alsohas an adjective form, as in “financial management.” Let’s explore these variations inmeaning

RAISING MONEYThe most common application of the term “finance” involves raising money to

acquire assets We’ve all heard people say they’re going to finance a car or a house.

When they say that, individuals usually mean they’re going to borrow money from abank to buy the item

The word is used similarly in business Companies finance assets when they raise

money to acquire those assets They do that by borrowing, selling stock, or usingmoney they’ve earned In recent years, many assets have been acquired through leas-

ing We say those items are lease financed.

A company itself is financed when money is raised to get it started or for

expan-sion Such money can come from borrowing or from selling stock To the extent the

money is borrowed, we say the company is debt financed To the extent it comes from selling stock, we say the firm is equity financed Equity implies financing with

an owner’s own money

Looking at Figure 1.1, we see that firms in the box on the right are raising money,financing things They do that by selling stocks and bonds to investors in the box on

the left The field of finance includes both sides of this money-raising transaction It

relates to the concerns of parties raising money and to those of parties providing it

Further, because the money raised flows through financial markets and institutions,their operation is a part of the field as well

The Changing Focus of Finance

Historically, the field of finance was narrowly limited to activity within financialmarkets Today the perspective has expanded in two directions

Companies:

Financial managements of firms raise and spend money

6 Part 1 Introduction to Financial Management

First, in modern finance a great deal of attention is given to the goals and activities

of the investor In the early days a complete description of a particular security (stock

or bond) was felt to be all an investor needed to make a decision comfortably Todaywe’ve become concerned with the notion of risk in investing and with how investors

put together groups of securities called portfolios to minimize that risk We’ll examine

these concepts at length in Chapter 9

The second direction of expansion involves the role and function of financialmanagement within firms Historically, financial managers were told how muchmoney their companies needed for particular projects, and they went outside in pur-suit of those funds They had little to do with deciding how much was needed or whatwas done with the money after it was raised Today financial managers are deeplyinvolved in those related decisions

FINANCIAL MANAGEMENTFinancial management means the management and control of money and money-related operations within a business Companies have finance departments that areresponsible for these functions

The executive in charge of the finance department is the company’s Chief Financial

Officer, abbreviated CFO The title Vice President of Finance is sometimes used

instead of CFO In either case, the position usually reports to the president of thecompany

The term “financial management” refers to the things the CFO and the financedepartment do These activities include keeping records, paying employees and ven-dors, receiving payments from customers, borrowing, purchasing assets, selling stock,paying dividends, and a number of others

It’s important to notice that accounting is included in this broad definition offinance and that the accounting function is usually found within the financedepartment

Business Decisions

Financial management also refers to the financial input that goes into general ness decisions This extremely important concept is best explained by an example.Suppose a domestic company is contemplating expanding overseas That’s likely to

busi-be a big decision discussed by the firm’s key executives over a long period of time.Each executive will have opinions and recommendations related to his or her ownarea of responsibility, such as marketing or manufacturing The CFO will similarlyhave opinions on how to set up the finance function in the new venture, how to doits accounting, and what banks to use In addition, he or she will probably have tosecure funding to support the project, either from a bank or by issuing securities.Beyond that, however, the CFO must form a judgment about the feasibility of theproject in terms of whether it will be profitable enough to justify its own cost In otherwords, the bottom line for most projects is money, and the responsibility for assessingthat bottom line falls to financial management (We’ll study the techniques used tomake this kind of decision called capital budgeting in Chapters 10, 11, and 12.)

Oversight

Another important aspect of financial management involves the relationship betweenfinance and other departments in the day-to-day management of the firm It’simportant to grasp the fact that finance is responsible for its own activities, but has aresponsibility for the operation of other departments as well

Wonder what careers

in finance are all

about? Visit

http://www.careers-in-business.com

http://

Chapter 1 Foundations 7

Let’s look into that idea a little more deeply Finance is responsible for money, butother departments deal in money too That’s because they have to spend it to do theirjobs, and their success is defined in terms of money For example, manufacturing’s taskmay be to produce some quantity of product, but doing the job properly involveskeeping costs low and using a reasonable level of inventory

The finance department generally has an oversight responsibility for the effective

management of the money other departments spend Hence, if manufacturing’s costsare too high or if it carries too much inventory, finance is responsible for callingattention to those facts and ensuring that corrective action is taken In other words,

part of finance’s job involves looking over everyone else’s shoulder to make sure they’re using money effectively.

THE PRICE OF SECURITIES—A LINK BETWEEN THE FIRM AND THE MARKET

The two sides of finance, investments and the financial management of the firm, areconnected by the fact that companies sell securities to investors in financial markets

A fundamental truth, which we’ll examine in detail later, is that investors buysecurities for the future cash flows that come from owning them Those cash flowsdepend on the issuing companies’ financial performance Hence, the prices investorsare willing to pay for securities depend on their expectations about how well theissuing companies are likely to do in the future in terms of profit Further, because thefuture is never guaranteed, the market is also concerned about the risk associated withexpected performance A perception of greater risk tends to lower investor interestand security prices

The link between company management and investments comes from this tionship between price and expected financial results Everything firms and theirmanagers do is watched by the market and has an impact on investors’ perceptions oflikely future performance and risk Those perceptions, in turn, determine the prices ofstocks and bonds

rela-In other words, the study of investments includes looking at the way companies aremanaged to estimate future performance At the same time, the management of com-panies includes consideration of how business decisions are perceived by investors andthe effects those perceptions have on the prices of stocks and bonds

FINANCE AND ACCOUNTING

In most industrial companies, the majority of the people involved in money-orientedactivities are accountants, so people sometimes get the idea that accounting andfinance are synonymous In fact they’re not, and it’s important to understand howthey fit together

Accounting is a system of record keeping designed to portray a firm’s operations tothe world in a fair and unbiased way The records are used periodically to producefinancial statements that present the company’s results to anyone who reads them

However, several other financial functions are performed in most companies

These include raising money, analyzing results, and handling relationships with siders such as banks, shareholders, and representatives of the investment community

out-Most of these functions are performed by the treasury department.

The finance department normally consists of both the accounting department headed

by the controller and the treasury department headed by the treasurer Both of these

positions report to the chief financial officer (CFO) The typical organization is