Foundations of finance 9th global edition by keown martin 2017

Preface 16 PArT 1 The Scope and Environment of Financial Management 26 1 An Introduction to the Foundations of Financial Management 26 2 The Financial Markets and Interest Rates 46 3 Un

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The Logic and Practice of Financial Management

Ninth Edition Global Edition

Foundations of Finance

Arthur J Keown

Virginia Polytechnic Institute and State University

R B Pamplin Professor of Finance

John D Martin

Baylor University Professor of Finance Carr P Collins Chair in Finance

J William Petty

Baylor University Professor of Finance

W W Caruth Chair in Entrepreneurship

The Pearson Series in Finance

Principles of Managerial Finance*

Principles of Managerial Finance—Brief

To my parents, from whom I learned the most.

Arthur J Keown

To the Martin women—wife Sally and daughter-in-law Mel, the Martin men

—sons Dave and Jess, and the Martin boys—grandsons Luke and Burke.

John D Martin

To Jack Griggs, who has been a most loyal and dedicated friend for over 55

years, always placing my interests above his own, and made life’s journey a lot

of fun along the way.

J William Petty

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Authorized adaptation from the United States edition, entitled Foundations of Finance: The Logic and Practice of Financial Management, 9 th Edition,

ISBN 978-0-13-408328-5 by Arthur J Keown, John D Martin and J William Petty, published by Pearson Education © 2017.

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Arthur J Keown is the Department Head and R B Pamplin Professor of

Finance at Virginia Polytechnic Institute and State University He received his

bachelor’s degree from Ohio Wesleyan University, his M.B.A from the University of

Michigan, and his doctorate from Indiana University An award-winning teacher, he

is a member of the Academy of Teaching Excellence; has received five Certificates of

Teaching Excellence at Virginia Tech, the W E Wine Award for Teaching Excellence,

and the Alumni Teaching Excellence Award; and in 1999 received the Outstanding

Faculty Award from the State of Virginia Professor Keown is widely published

in academic journals His work has appeared in the Journal of Finance, Journal of

Financial Economics, Journal of Financial and Quantitative Analysis, Journal of Financial

Research, Journal of Banking and Finance, Financial Management, Journal of Portfolio

Management, and many others In addition to Foundations of Finance, two others of his

books are widely used in college finance classes all over the country—Basic Financial

Management and Personal Finance: Turning Money into Wealth Professor Keown is a

Fellow of the Decision Sciences Institute, was a member of the Board of Directors of

the Financial Management Association, and is the head of the finance department

at Virginia Tech In addition, he served as the co-editor of the Journal of Financial

Research for 6½ years and as the co-editor of the Financial Management Association’s

Survey and Synthesis series for 6 years He lives with his wife in Blacksburg, Virginia,

where he collects original art from Mad Magazine.

John D Martin holds the Carr P Collins Chair in Finance in the Hankamer

School of Business at Baylor University, where he was selected as the outstanding

professor in the EMBA program multiple times Professor Martin joined the Baylor

faculty in 1998 after spending 17 years on the faculty of the University of Texas at

Austin Over his career he has published over 50 articles in the leading finance

jour-nals, including papers in the Journal of Finance, Journal of Financial Economics, Journal

of Financial and Quantitative Analysis, Journal of Monetary Economics, and Management

Science His recent research has spanned issues related to the economics of

uncon-ventional energy sources, the hidden cost of venture capital, and the valuation of

firms filing Chapter 11 He is also co-author of several books, including Financial

Management: Principles and Practice (13th ed., Prentice Hall), Foundations of Finance

(9th ed., Prentice Hall), Theory of Finance (Dryden Press), Financial Analysis (3rd ed.,

McGraw-Hill), Valuation: The Art and Science of Corporate Investment Decisions (3rd ed.,

Prentice Hall), and Value Based Management with Social Responsibility (2nd ed., Oxford

University Press)

About the Authors

J William Petty, PhD, Baylor University, is Professor of Finance and

W W Caruth Chair of Entrepreneurship Dr Petty teaches entrepreneurial finance

at both the undergraduate and graduate levels He is a University Master Teacher

In 2008, the Acton Foundation for Entrepreneurship Excellence selected him as the National Entrepreneurship Teacher of the Year His research interests include the financing of entrepreneurial firms and shareholder value-based management He

has served as the co-editor for the Journal of Financial Research and the editor of the Journal of Entrepreneurial Finance He has published articles in various academic and professional journals, including Journal of Financial and Quantitative Analysis, Financial Management, Journal of Portfolio Management, Journal of Applied Corporate Finance, and Accounting Review Dr Petty is co-author of a leading textbook in small business and entrepreneurship, Small Business Management: Launching and Growing Entrepreneurial Ventures He also co-authored Value-Based Management: Corporate America’s Response

to the Shareholder Revolution (2010) He serves on the Board of Directors of a publicly

traded oil and gas firm Finally, he serves on the Board of the Baylor Angel Network,

a network of private investors who provide capital to start-ups and early-stage companies

Preface 16

PArT 1 The Scope and Environment

of Financial Management 26

1 An Introduction to the Foundations of Financial Management 26

2 The Financial Markets and Interest Rates 46

3 Understanding Financial Statements and Cash Flows 78

4 Evaluating a Firm’s Financial Performance 130

PArT 2 The Valuation of Financial Assets 176

5 The Time Value of Money 176

6 The Meaning and Measurement of Risk and Return 220

7 The Valuation and Characteristics of Bonds 260

8 The Valuation and Characteristics of Stock 292

9 The Cost of Capital 318

PArT 3 Investment in Long-Term Assets 350

10 Capital-Budgeting Techniques and Practice 350

11 Cash Flows and Other Topics in Capital Budgeting 392

PArT 4 Capital Structure and Dividend Policy 430

12 Determining the Financing Mix 430

13 Dividend Policy and Internal Financing 468

PArT 5 Working-Capital Management and International

Web Appendix A Using a Calculator

Available online at www.myfinancelab.com

Glossary 560 Indexes 569

Brief Contents

Avoiding Financial Crisis—Back to the Principles 34 The Essential Elements of Ethics and Trust 35

The Role of Finance in Business 36

Why Study Finance? 36 The Role of the Financial Manager 37

The Legal Forms of Business Organization 38

Sole Proprietorships 38 Partnerships 38 Corporations 39 Organizational Form and Taxes: The Double Taxation on Dividends 39 S-Corporations and Limited Liability Companies (LLCs) 40

Which Organizational Form Should Be Chosen? 40

Finance and the Multinational Firm: The New Role 41

Chapter Summaries 42 • Review Questions 44 • Mini Case 45

2 The Financial Markets and Interest Rates 46

Financing of Business: The Movement of Funds Through the Economy 48

Public Offerings Versus Private Placements 49 Primary Markets Versus Secondary Markets 50 The Money Market Versus the Capital Market 51 Spot Markets Versus Futures Markets 51 Stock Exchanges: Organized Security Exchanges Versus Over-the-Counter Markets, a Blurring Difference 51

Selling Securities to the Public 53

Functions 53 Distribution Methods 54 Private Debt Placements 55 Flotation Costs 57

Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley Act 57

Rates of Return in the Financial Markets 58

Rates of Return over Long Periods 58 Interest Rate Levels in Recent Periods 59

Interest Rate Determinants in a Nutshell 62

Estimating Specific Interest Rates Using Risk Premiums 62 Real Risk-Free Interest Rate and the Risk-Free Interest Rate 63 Real and Nominal Rates of Interest 63

Inflation and Real Rates of Return: The Financial Analyst’s Approach 65 The Term Structure of Interest Rates 67

Shifts in the Term Structures of Interest Rates 67 What Explains the Shape of the Term Structure? 69

Chapter Summaries 71 • Review Questions 74 • Study Problems 74 • Mini Case 77

3 Understanding Financial Statements and Cash Flows 78

The Income Statement 80

Coca-Cola’s Income Statement 82 Restating Coca-Cola’s Income Statement 83

The Balance Sheet 85

Types of Assets 85 Types of Financing 87 Coca-Cola’s Balance Sheet 89 Working Capital 90

Measuring Cash Flows 93

Profits Versus Cash Flows 93 The Beginning Point: Knowing When a Change in the Balance Sheet Is a Source

or Use of Cash 95 Statement of Cash Flows 95 Concluding Suggestions for Computing Cash Flows 102 What Have We Learned about Coca-Cola? 103

GAAP and IFRS 103 Income Taxes and Finance 104

Computing Taxable Income 104 Computing the Taxes Owed 105

The Limitations of Financial Statements and Accounting Malpractice 107

Chapter Summaries 109 • Review Questions 112 • Study Problems 113 • Mini Case 121

Appendix 3A: Free Cash Flows 124

Computing Free Cash Flows 124 Computing Financing Cash Flows 127

Study Problems 128

4 Evaluating a Firm’s Financial Performance 130

The Purpose of Financial Analysis 130 Measuring Key Financial Relationships 134

Question 1: How Liquid Is the Firm—Can It Pay Its Bills? 135 Question 2: Are the Firm’s Managers Generating Adequate Operating Profits

on the Company’s Assets? 140 Managing Operations 142 Managing Assets 143 Question 3: How Is the Firm Financing Its Assets? 147 Question 4: Are the Firm’s Managers Providing a Good Return on the Capital Provided by the Company’s Shareholders? 150

Question 5: Are the Firm’s Managers Creating Shareholder Value? 155

The Limitations of Financial Ratio Analysis 162

Chapter Summaries 163 • Review Questions 166 • Study Problems 166

• Mini Case 174

PArT 2 The Valuation of Financial Assets 176

5 The Time Value of Money 176

Compound Interest, Future Value, and Present Value 178

Using Timelines to Visualize Cash Flows 178 Techniques for Moving Money Through Time 181 Two Additional Types of Time Value of Money Problems 186 Applying Compounding to Things Other Than Money 187 Present Value 188

Annuities 192

Compound Annuities 192 The Present Value of an Annuity 194 Annuities Due 196

Amortized Loans 197

Making Interest Rates Comparable 199

Calculating the Interest Rate and Converting It to an EAR 201 Finding Present and Future Values With Nonannual Periods 202 Amortized Loans With Monthly Compounding 205

The Present Value of an Uneven Stream and Perpetuities 206

The Investor’s Required Rate of Return 246

The Required Rate of Return Concept 246 Measuring the Required Rate of Return 246

Chapter Summaries 249 • Review Questions 253 • Study Problems 253

Terminology and Characteristics of Bonds 263

Claims on Assets and Income 263 Par Value 263

Coupon Interest Rate 264 Maturity 264

Call Provision 264 Indenture 264 Bond Ratings 265

Defining Value 266 What Determines Value? 268 Valuation: The Basic Process 269 Valuing Bonds 270

Bond Yields 276

Yield to Maturity 276 Current Yield 278

Bond Valuation: Three Important Relationships 279

Chapter Summaries 284 • Review Questions 287 • Study Problems 288

• Mini Case 291

8 The Valuation and Characteristics

of Stock 292

Preferred Stock 293

The Characteristics of Preferred Stock 294

Valuing Preferred Stock 295 Common Stock 299

The Characteristics of Common Stock 299

Valuing Common Stock 301 The Expected Rate of Return of Stockholders 306

The Expected Rate of Return of Preferred Stockholders 307 The Expected Rate of Return of Common Stockholders 308

Chapter Summaries 311 • Review Questions 314 • Study Problems 314

• Mini Case 317

9 The Cost of Capital 318

The Cost of Capital: Key Definitions and Concepts 319

Opportunity Costs, Required Rates of Return, and the Cost of Capital 319

The Firm’s Financial Policy and the Cost of Capital 320

Determining the Costs of the Individual Sources

of Capital 321

The Cost of Debt 321 The Cost of Preferred Stock 323 The Cost of Common Equity 325 The Dividend Growth Model 326 Issues in Implementing the Dividend Growth Model 327 The Capital Asset Pricing Model 328

Issues in Implementing the CAPM 329

The Weighted Average Cost of Capital 331

Capital Structure Weights 332 Calculating the Weighted Average Cost of Capital 332

Calculating Divisional Costs of Capital 335

Estimating Divisional Costs of Capital 335 Using Pure Play Firms to Estimate Divisional WACCs 335 Using a Firm’s Cost of Capital to Evaluate New Capital Investments 337

Chapter Summaries 341 • Review Questions 343 • Study Problems 344

• Mini Cases 348

PArT 3 Investment in Long-Term Assets 350

10 Capital-Budgeting Techniques and Practice 350

Finding Profitable Projects 351 Capital-Budgeting Decision Criteria 352

The Payback Period 352 The Net Present Value 356 Using Spreadsheets to Calculate the Net Present Value 359 The Profitability Index (Benefit–Cost Ratio) 359

The Internal Rate of Return 362

Computing the IRR for Uneven Cash Flows with a Financial Calculator 364 Viewing the NPV–IRR Relationship: The Net Present Value Profile 365 Complications with the IRR: Multiple Rates of Return 367

The Modified Internal Rate of Return (MIRR) 368 Using Spreadsheets to Calculate the MIRR 371

A Last Word on the MIRR 371

Capital Rationing 372

The Rationale for Capital Rationing 373 Capital Rationing and Project Selection 373

Ranking Mutually Exclusive Projects 374

The Size-Disparity Problem 374 The Time-Disparity Problem 375 The Unequal-Lives Problem 376

Chapter Summaries 380 • Review Questions 383 • Study Problems 383

• Mini Case 390

11 Cash Flows and Other Topics in Capital Budgeting 392

Guidelines for Capital Budgeting 393

Use Free Cash Flows Rather Than Accounting Profits 393 Think Incrementally 393

Beware of Cash Flows Diverted from Existing Products 394 Look for Incidental or Synergistic Effects 394

Work in Working-Capital Requirements 394 Consider Incremental Expenses 395 Remember That Sunk Costs Are Not Incremental Cash Flows 395 Account for Opportunity Costs 395

Decide If Overhead Costs Are Truly Incremental Cash Flows 395 Ignore Interest Payments and Financing Flows 396

Calculating a Project’s Free Cash Flows 396

What Goes into the Initial Outlay 396 What Goes into the Annual Free Cash Flows over the Project’s Life 397 What Goes into the Terminal Cash Flow 399

Calculating the Free Cash Flows 399

A Comprehensive Example: Calculating Free Cash Flows 403

Options in Capital Budgeting 406

The Option to Delay a Project 407 The Option to Expand a Project 407 The Option to Abandon a Project 408 Options in Capital Budgeting: The Bottom Line 408

Risk and the Investment Decision 409

What Measure of Risk Is Relevant in Capital Budgeting? 410 Measuring Risk for Capital-Budgeting Purposes with a Dose of Reality—Is Systematic Risk All There Is? 411

Incorporating Risk into Capital Budgeting 411 Risk-Adjusted Discount Rates 411

Measuring a Project’s Systematic Risk 414 Using Accounting Data to Estimate a Project’s Beta 415 The Pure Play Method for Estimating Beta 415 Examining a Project’s Risk Through Simulation 415 Conducting a Sensitivity Analysis Through Simulation 417

Chapter Summaries 418 • Review Questions 420 • Study Problems 420

PArT 4 Capital Structure and Dividend Policy 430

12 Determining the Financing Mix 430Understanding the Difference Between Business and Financial Risk 432

Business Risk 433 Operating Risk 433

Break-Even Analysis 433

Essential Elements of the Break-Even Model 434 Finding the Break-Even Point 436

The Break-Even Point in Sales Dollars 437

Sources of Operating Leverage 438

Financial Leverage 440 Combining Operating and Financial Leverage 442

Capital Structure Theory 444

A Quick Look at Capital Structure Theory 446 The Importance of Capital Structure 446 Independence Position 446

The Moderate Position 448 Firm Value and Agency Costs 450 Agency Costs, Free Cash Flow, and Capital Structure 452 Managerial Implications 452

The Basic Tools of Capital Structure Management 453

EBIT-EPS Analysis 453 Comparative Leverage Ratios 456 Industry Norms 457

Net Debt and Balance-Sheet Leverage Ratios 457

A Glance at Actual Capital Structure Management 457

Chapter Summaries 460 • Review Questions 463 • Study Problems 463

• Mini Cases 466

13 Dividend Policy and Internal Financing 468Key Terms 469

Does Dividend Policy Matter to Stockholders? 470

Three Basic Views 470 Making Sense of Dividend Policy Theory 473 What Are We to Conclude? 475

The Dividend Decision in Practice 476

Legal Restrictions 476 Liquidity Constraints 476 Earnings Predictability 477 Maintaining Ownership Control 477 Alternative Dividend Policies 477 Dividend Payment Procedures 477

Stock Dividends and Stock Splits 478 Stock Repurchases 479

A Share Repurchase as a Dividend Decision 480 The Investor’s Choice 481

A Financing or an Investment Decision? 482 Practical Considerations—The Stock Repurchase Procedure 482

Chapter Summaries 483 • Review Questions 485 • Study Problems 486

on DFN 493 Analyzing the Effects of Sales Growth on a Firm’s DFN 494

Limitations of the Percent of Sales Forecasting Method 497 Constructing and Using a Cash Budget 498

Budget Functions 498 The Cash Budget 499

Chapter Summaries 501 • Review Questions 502 • Study Problems 503

• Mini Case 508

15 Working-Capital Management 510

Managing Current Assets and Liabilities 511

The Risk–Return Trade-Off 512 The Advantages of Current versus Long-term Liabilities: Return 512 The Disadvantages of Current versus Long-term Liabilities: Risk 512

Determining the Appropriate Level of Working Capital 513

The Hedging Principle 513 Permanent and Temporary Assets 514 Temporary, Permanent, and Spontaneous Sources of Financing 514 The Hedging Principle: A Graphic Illustration 515

The Cash Conversion Cycle 516 Estimating the Cost of Short-Term Credit Using the Approximate Cost-of-Credit Formula 518

Sources of Short-Term Credit 520

Unsecured Sources: Accrued Wages and Taxes 521 Unsecured Sources: Trade Credit 522

Unsecured Sources: Bank Credit 523 Unsecured Sources: Commercial Paper 525

Secured Sources: Accounts-Receivable Loans 527 Secured Sources: Inventory Loans 529

Chapter Summaries 530 • Review Questions 533 • Study Problems 534

16 International Business Finance 538

The Globalization of Product and Financial Markets 539 Foreign Exchange Markets and Currency Exchange Rates 540

Foreign Exchange Rates 541 What a Change in the Exchange Rate Means for Business 541 Exchange Rates and Arbitrage 544

Asked and Bid Rates 544 Cross Rates 544

Types of Foreign Exchange Transactions 546 Exchange Rate Risk 548

Interest Rate Parity 550 Purchasing-Power Parity and the Law of One Price 551

The International Fisher Effect 552

Capital Budgeting for Direct Foreign Investment 552

Foreign Investment Risks 553

Chapter Summaries 554 • Review Questions 556 • Study Problems 557

• Mini Case 558

Web 17 Cash, Receivables, and Inventory Management

Web Appendix A Using a Calculator

Glossary 560

Indexes 569

The study of finance focuses on making decisions that enhance the value of the firm

This is done by providing customers with the best products and services in a

cost-effective way In a sense we, the authors of Foundations of Finance, share the same

purpose We have tried to create a product that provides value to our customers—

both students and instructors who use the text It was this priority that led us to write

Foundations of Finance: The Logic and Practice of Financial Management, which was the

first “shortened book” of financial management when it was first published This text launched a trend that has since been followed by all the major competing texts

in this market The text broke new ground not only by reducing the breadth of rials covered but also by employing a more intuitive approach to presenting new material From that first edition, the text has met with success beyond our expecta-tions for eight editions For that success, we are eternally grateful to the multitude of finance instructors who have chosen to use the text in their classrooms

mate-New to the Ninth Edition

Technology is ever present in our lives today, and we are beginning to see its tive use in education One form of learning technology that we believe has great

effec-merit today is the lecture video For all the numbered in-text examples in the Ninth

Edition, we have recorded brief (10- to 15-minute) lecture videos that students can replay as many times as they need to help them understand more fully each of the in-text examples We are confident that many students will enjoy having the authors

“tutoring” them when it comes to the primary examples in the text The videos can

be found in the eText within MyFinanceLab

In addition to the innovations of this edition, we have made some chapter updates in response to the continued development of financial thought, reviewer comments, and the recent economic crisis Some of these changes include:

chapter-by-Chapter 1

An Introduction to the Foundations of Financial Management

Chapter 2

The Financial Markets and Interest Rates

rates that characterize today’s markets

problems

Chapter 3

Understanding Financial Statements and Cash Flows

understand financial statements

Preface

◆ More intuitive presentation of cash flows

statement

Chapter 4

Evaluating a Firm’s Financial Performance

we evaluate a firm’s financial performance, compared to industry norms or a peer group In this case, we compare Coca-Cola’s financial performance to that of PepsiCo, a major competitor

industry

with how business managers talk about liquidity

Chapter 5

The Time Value of Money

end-of-chapter questions dealing with calculation of the effective annual rate

Chapter 6

The Meaning and Measurement of Risk and Return

long term with different types of security investments

presented throughout the chapter to illustrate the concepts and applications in the chapter

Chapter 7

The Valuation and Characteristics of Bonds

Chapter 8

The Valuation and Characteristics of Stock

Journal

Chapter 9

The Cost of Capital

Chapter 10

Capital-Budgeting Techniques and Practice

build the Shanghai Disney Resort

inter-nal rate of return that not only summarizes the tool, but also provides important caveats concerning its use

Chapter 11

Cash Flows and Other Topics in Capital Budgeting

cash flows when it introduced the Prius

Chapter 12

Determining the Financing Mix

Chapter 13

Dividend Policy and Internal Financing

capital gains

Chapter 14

Short-Term Financial Planning

Chapter 15

Working-Capital Management

Chapter 16

International Business Finance

deals with the implications of exchange rate changes

Web Chapter 17

Cash, Receivables, and Inventory Management

Pedagogy That Works

In our opinion, the success of this textbook derives from our focus on maintaining

pedagogy that works We endeavor to provide students with a conceptual

understand-ing of the financial decision-makunderstand-ing

process that includes a survey of the

tools and techniques of finance For

the student, it is all too easy to lose

sight of the logic that drives finance

and to focus instead on

memoriz-ing formulas and procedures As

a result, students have a difficult

time understanding the

interrela-tionships among the topics covered

Moreover, later in life, when the

problems encountered do not match

the textbook presentation, students

may find themselves unprepared

to abstract from what they have

learned We have worked to be “good at the basics.” To achieve this goal, we have

refined the book over the last eight editions to include the following features

Building on Foundational Finance Principles

Chapter 1 presents five foundational principles of finance which are the threads that

bind all the topics of the book Then throughout the text, we provide reminders of

the foundational principles in “Remember Your Principles” boxes

The five principles of finance allow us to provide an introduction to financial decision making rooted in current financial theory and in the current state of world

economic conditions What results is an introductory treatment of a discipline rather

than the treatment of a series of isolated financial problems that managers encounter

Use of an Integrated Learning System

The text is organized around the learning objectives that appear at the beginning of

each chapter to provide the instructor and student with an easy-to-use integrated

learning system Numbered icons identifying each objective appear next to the

related material throughout the text and in the summary, allowing easy location of

material related to each objective

A Focus on Valuation

Although many professors and instructors make valuation the central theme of their

course, students often lose sight of this focus when reading their text We reinforce

this focus in the content and organization of our text in some very concrete ways:

foun-dation for the valuation of any investment

“how is the value of the enterprise affected?”

Real-World Opening Vignettes

Each chapter begins with a story about a current, real-world company faced with a

financial decision related to the chapter material that follows These vignettes have

ply be impossible, but fortunately that is unnecessary To employ this goal, we need not consider every stock price change to be a market interpretation of the worth of our decisions Other factors, such as changes in the economy, also affect stock prices

What we do focus on is the effect that our decision should have on the stock price if

everything else were held constant The market price of the firm’s stock reflects the value of the firm as seen by its owners and takes into account the complexities and complications of the real-world risk As we follow this goal throughout our discus- sions, we must keep in mind one more question: Who exactly are the shareholders?

The answer: Shareholders are the legal owners of the firm.

Concept Check

1 What is the goal of the firm?

2 How would you apply this goal in practice?

Five Principles That Form the Foundations

of Finance

To the first-time student of finance, the subject matter may seem like a collection of unrelated decision rules This impression could not be further from the truth In fact, our decision rules, and the logic that underlies them, spring from five simple princi- ples that do not require knowledge of finance to understand These five principles guide the financial manager in the creation of value for the firm’s owners (the stock- holders).

As you will see, although it is not necessary to understand finance to understand these principles, it is necessary to understand these principles in order to understand finance These principles may at first appear simple or even trivial, but they provide the driving force behind all that follows, weaving together the concepts and tech- niques presented in this text, and thereby allowing us to focus on the logic underly- ing the practice of financial management Now let’s introduce the five principles.

Principle 1: Cash Flow Is What Matters

You probably recall from your accounting classes that a company’s profits can differ dramatically from its cash flows, which we will review in Chapter 3 But for now understand that cash flows, not profits, represent money that can be spent

Consequently, it is cash flow, not profits, that determines the value of a business For this reason when we analyze the consequences of a managerial decision, we focus on the resulting cash flows, not profits.

In the movie industry, there is a big difference between accounting profits and cash flow Many a movie is crowned a success and brings in plenty of cash flow for the studio but doesn’t produce a profit Even some of the most successful box office

hits—Forrest Gump, Coming to America, Batman, My Big Fat Greek Wedding, and the TV series Babylon 5—realized no accounting profits at all after accounting for various

movie studio costs That’s because “Hollywood Accounting” allows for overhead costs not associated with the movie to be added on to the true cost of the movie In

fact, the movie Harry Potter and the Order of the Phoenix, which grossed almost $1 lion worldwide, actually lost $167 million according to the accountants Was Harry

bil-Potter and the Order of the Phoenix a successful movie? It certainly was—in fact, it was

the 27th highest grossing film of all time Without question, it produced cash, but it didn’t make any profits.

LO 2 Understand the basic principles of finance, their importance, and the importance of ethics and trust.

1 principle

been carefully prepared to stimulate student interest in the topic to come and can be used as a lecture tool to provoke class discussion.

A Step-by-Step Approach to Problem Solving and Analysis

As anyone who has taught the core undergraduate finance course knows, students demonstrate a wide range of math comprehension and skill Students who do not have the math skills needed to master the subject sometimes end up memorizing for-mulas rather than focusing on the analysis of business decisions using math as a tool

We address this problem in terms of both text content and pedagogy

necessary We do not present math for its own sake

solve problems To help with this process, numbered chapter examples appear throughout the book All of these examples follow a very detailed and struc-tured three-step approach to problem solving that helps students develop their problem-solving skills:

Step 1: Formulate a Solution Strategy For example, what is the appropriate

for-mula to apply? How can a calculator or spreadsheet be used to “crunch the numbers”?

Step 2: Crunch the Numbers Here we provide a completely worked out

step-by-step solution We present first a description of the solution in prose and then a corresponding mathematical implementation

Step 3: Analyze Your Results We end each solution with an analysis of what the

solution means This stresses the point that problem solving is about analysis and decision making Moreover, in this step we emphasize that decisions are often based on incomplete information, which requires the exercise of managerial judgment, a fact of life that is often learned on the job

“Can You Do It?” and

“Did You Get It?”

The text provides examples for the students to work at the conclusion

of each major section of a chapter, which we call “Can You Do It?,” fol-lowed by “Did You Get It?” later in the chapter This tool provides an essential ingredient in the building-block approach to the material that

we use

Concept Check

At the end of major chapter sections

we include a brief list of questions that are designed to highlight key ideas presented in the section

CHAPTER 2 • The Financial Markets and Interest Rates 41

someone for 1 year at a nominal rate of interest of 11.3 percent This means you will get back $111.30 in 1 year But if during the year, the prices of goods and services rise

by 5 percent, it will take $105 at year-end to purchase the same goods and services that $100 purchased at the beginning of the year What was your increase in purchas- ing power over the year? The quick and dirty answer is found by subtracting the inflation rate from the nominal rate, 11.3% 2 5% 5 6.3%, but this is not exactly cor- rect We can also express the relationship among the nominal interest rate, the rate of inflation (that is, the inflation premium), and the real rate of interest as follows:

1 1 nominal interest rate 5 (1 1 real rate of interest)(1 1 rate of inflation) (2-3)

Solving for the nominal rate of interest, Nominal interest rate

5 real rate of interest 1 rate of inflation 1 (real rate of interest) (rate of inflation)

Consequently, the nominal rate of interest is equal to the sum of the real rate of interest, the inflation rate, and the product of the real rate and the inflation rate This relationship among nominal rates, real rates, and the rate of inflation has come to be

called the Fisher effect What does the product of the real rate of interest and the

infla-tion rate represent? It represents the fact that the money you earn on your investment

is worth less because of inflation All this demonstrates that the observed nominal

rate of interest includes both the real rate and an inflation premium.

Substituting into equation (2-3) using a nominal rate of 11.3 percent and an tion rate of 5 percent, we can calculate the real rate of interest as follows:

infla-Nominal or quoted rate of interest 5real rate of interest 1 inflation rate 1interest and the inflation rateproduct of the real rate of 0.113 5 real rate of interest 1 0.05 1 0.05 3 real rate of interest 0.063 5 1.05 3 real rate of interest

0.063/1.05 5 real rate of interest

Solving for the real rate of interest:

Real rate of interest = 0.06 = 6%

Thus, at the new higher prices, your purchasing power will have increased by only 6 percent, although you have $11.30 more than you had at the start of the year To see why, let’s assume that at the outset of the year, one unit of the market basket of goods and services cost $1, so you could purchase 100 units with your $100 At the end of the year, you have $11.30 more, but each unit now costs $1.05 (remember the 5 percent rate of inflation) How many units can you buy at the end of the year? The answer is

$111.30 4 $1.05 5 106, which represents a 6 percent increase in real purchasing power 2

Inflation and Real Rates of Return: The Financial Analyst’s Approach

Although the algebraic methodology presented in the previous section is strictly rect, few practicing analysts or executives use it Rather, they employ some version of

cor-2 In Chapter 5, we will study more about the time value of money.

CAN YOU DO IT?

Solving for the Real Rate of Interest

Your banker just called and offered you the chance to invest your savings for 1 year at a quoted rate of 10 percent You also saw on the news that the inflation rate is 6 percent What is the real rate of interest you would be earning if you made the investment? (The solution can be found on page 42.)

M02_KEOW3285_09_SE_C02.indd 41 28/11/15 2:54 PM

42 PART 1 • The Scope and Environment of Financial Management

the following relationship (which comes from equation (2-2)), an approximation method, to estimate the real rate of interest over a selected past time frame.

Nominal interest rate 2 inflation rate > real interest rate The concept is straightforward, but its implementation requires that several judg- ments be made For example, suppose we want to use this relationship to determine the real risk-free interest rate Which interest rate series and maturity period should

be used? Suppose we settle for using some U.S Treasury security as a surrogate for a nominal risk-free interest rate Then, should we use the yield on 3-month U.S

Treasury bills or, perhaps, the yield on 30-year Treasury bonds? There is no absolute answer to the question.

So, we can have a real risk-free short-term interest rate, as well as a real risk-free long-term interest rate, and several variations in between In essence, it just depends

on what the analyst wants to accomplish Of course we could also calculate the real rate of interest on some rating class of 30-year corporate bonds (such as Aaa-rated bonds) and have a risky real rate of interest as opposed to a real risk-free interest rate.

Furthermore, the choice of a proper inflation index is equally challenging Again,

we have several choices We could use the consumer price index, the producer price index for finished goods, or some price index out of the national income accounts, such as the gross domestic product chain price index Again, there is no precise scien- tific answer as to which specific price index to use Logic and consistency do narrow the boundaries of the ultimate choice.

Let’s tackle a very basic (simple) example Suppose that an analyst wants to mate the approximate real interest rate on (1) 3-month Treasury bills, (2) 30-year Treasury bonds, and (3) 30-year Aaa-rated corporate bonds over the 1990–2014 time frame Furthermore, the annual rate of change in the consumer price index (mea- sured from December to December) is considered a logical measure of past inflation experience Most of our work is already done for us in Table 2-2 Some of the data from Table 2-2 are displayed here.

esti-Security Mean Nominal Yield (%) Mean Inflation Rate (%) Inferred Real Rate (%)

3-month Treasury bills 3.04 2.64 0.40 30-year Treasury bonds 5.49 2.64 2.85 30-year Aaa-rated

corporate bonds 6.35 2.64 3.71

Notice that the mean yield over the 25 years from 1990 through 2014 on all three classes of securities has been used Likewise, the mean inflation rate over the same time period has been used as an estimate of the inflation premium The last column provides the approximation for the real interest rate on each class of securities.

Thus, over the 25-year examination period the real rate of interest on 3-month Treasury bills was 0.40 percent versus 2.85 percent on 30-year Treasury bonds,

DID YOU GET IT?

Solving for the Real Rate of Interest

Nominal or quoted rate of interest

5 real rate of interest

1 inflation rate

1 product of the real rate of interest and the inflation rate 0.10 5 real rate of interest 1 0.06 1 0.06 3 real rate of interest 0.04 5 1.06 3 real rate of interest

Solving for the real rate of interest:

Real rate of interest 5 0.0377 5 3.77%

M02_KEOW3285_09_SE_C02.indd 42 28/11/15 2:54 PM

right thing.” In a sense, we can think of laws as a set of rules that reflect the values of

a society as a whole.

You might ask yourself, “As long as I’m not breaking society’s laws, why should I care about ethics?” The answer to this question lies in consequences Everyone makes errors of judgment in business, which is to be expected in an uncertain world But ethi- cal errors are different Even if they don’t result in anyone going to jail, they tend to end careers and thereby terminate future opportunities Why? Because unethical behavior destroys trust, and businesses cannot function without a certain degree of trust.

Concept Check

1 According to Principle 3, how do investors decide where to invest their money?

2 What is an efficient market?

3 What is the agency problem, and why does it occur?

4 Why are ethics and trust important in business?

The Role of Finance in Business

Finance is the study of how people and businesses evaluate investments and raise capital to fund them Our interpretation of an investment is quite broad When Apple designed its Apple Watch, it was clearly making a long-term investment The firm had to devote considerable expenses to designing, producing, and marketing the device with the hope that it would eventually become indispensable to everyone

Similarly, Apple is making an investment decision whenever it hires a fresh new graduate, knowing that it will be paying a salary for at least 6 months before the employee will have much to contribute.

Thus, the study of finance addresses three basic types of issues:

1 What long-term investments should the firm undertake? This area of finance is

generally referred to as capital budgeting.

2 How should the firm raise money to fund these investments? The firm’s funding

choices are generally referred to as capital structure decisions.

3 How can the firm best manage its cash flows as they arise in its day-to-day

operations? This area of finance is generally referred to as working capital

management

We’ll be looking at each of these three areas of business finance—capital ing, capital structure, and working capital management—in the chapters ahead.

budget-Why Study Finance?

Even if you’re not planning a career in finance, a working knowledge of finance will take you far in both your personal and professional life.

Those interested in management will need to study topics such as strategic ning, personnel, organizational behavior, and human relations, all of which involve spending money today in the hopes of generating more money in the future For example, it has been estimated that it would cost Apple over $1 billion to develop a new electric car, and that doesn’t guarantee the car would be a success After all, GM made a strategic decision to introduce an electric car and invested $740 million to produce the Chevy Volt, only to find car buyers balking at the $40,000 sticker price

plan-Similarly, marketing majors need to understand and decide how aggressively to price products, the amount to spend on advertising, and what media to use for those ads Since aggressive marketing today costs money but allows firms to reap rewards

in the future, it should be viewed as an investment that the firm needs to finance

Production and operations management majors need to understand how best to

LO 3 Describe the role of

finance in business.

capital budgeting the decision-

making process with respect to

investment in fixed assets.

capital structure decisions the

decision-making process with funding

choices and the mix of long-term

sources of funds.

working capital management the

management of the firm’s current

assets and short-term financing.

Financial Decision Tools

A feature that has proven popular with students has been our recapping of key equations shortly after their discussion Students get to see an equa-tion within the context of related equations

Financial Calculators and Excel Spreadsheets

The use of financial calculators and Excel spreadsheets has been integrated throughout the text, especially with respect to presentation of the time value of money and valuation Where appropriate, actual calculator and spreadsheet solutions appear in the text

Chapter Summaries That Bring Together cepts, Terminology, and Applications

Con-The chapter summaries have been written in a way that connects them to the chapter sections and learning objectives For each learning objective, the student sees

in-in one place the concepts, new termin-inology, and key equations that were presented

in the objective

Revised Study Problems

With each edition, we have provided new and revised end-of-chapter study lems to refresh their usefulness in teaching finance Also, the study problems con-tinue to be organized according to learning objective so that both the instructor and student can readily align text and problem materials

prob-Comprehensive Mini Cases

A comprehensive Mini Case appears at the end of almost every chapter, covering all the major topics included in that chapter Each Mini Case can be used as a lecture or review tool by the professor For the students, the Mini Case provides an opportunity to apply all the concepts presented within the chapter in a realistic setting, thereby strengthening their understanding of the material

Evaluating Disney’s Return on Equity

The net income and the common equity invested by Disney’s shareholders (expressed

in $ millions) are provided here, along with the average return on equity for the industry Evaluate the rate of return being earned on the common stockholders’ equity investment In addition to comparing the Disney Corporation’s return on equity to the industry’s, consider the implications Disney’s operating return on assets and its debt financing practices have on the firm’s return

on equity.

Net income $8,355

Common equity Common stock (par value) $34,301

Paid-in capital 0 Retained earnings 53,734

Treasury stock (43,077)

Industry average return on equity 12.31%

STEP 1: Formulate a Decision Strategy

To evaluate return on equity, recall equation (4-14):

Return on equity =total common equitynet income

STEP 2: Crunch the Numbers

First, we determine Disney’s total common equity to be $44.958 billion by adding all the individual equity items shown above Then dividing net income of $8.355 billion

by the total common equity, we find Disney’s return on equity to be 18.58 percent ( 18.58% = $8.355 billion net income , $44.958 billion total common equity), compared to 12.31 percent for the industry average.

STEP 3: Analyze Your Results

Disney’s higher return on equity is due to the firm having a higher operating return

on assets (13.54 percent for Coca-Cola versus 7.50 percent for the industry) and using more debt financing (46.6 percent debt ratio for Disney, compared to 34.21 percent for the industry).

FINANCIAL DECISION TOOLS

Name of Tool Formula What It Tells You

Return on equity net income

total common equity

Measures the shareholders’ accounting return on their investment.

Concept Check

1 How is a company’s return on equity related to the firm’s operating return on assets?

2 How is a company’s return on equity related to the firm’s debt ratio?

3 What is the upside of debt financing? What is the downside?

My Finance Lab Video

M04_KEOW3285_09_SE_C04.indd 130 02/12/15 2:00 PM

EXAMPLE 5.4

Calculating the Discounted Value to Be Received in 10 Years

What is the present value of $500 to be received 10 years from today if our discount

rate is 6 percent?

STEP 1: Formulate a Solution Strategy

The present value to be received can be calculated using equation (5-2) as follows:

STEP 2: Crunch the Numbers

Substituting FV = $500, n = 10, and r = 6 percent into equation (5-2), we find:

(1 + 0.06)10d = $500(0.5584) = $279.20

STEP 3: Analyze Your Results

Thus, the present value of the $500 to be received in 10 years is $279.20

FIGURE 5-3 The Present Value of $100 to Be Received at a Future Date and

Discounted Back to the Present at 0, 5, 10, and 15 Percent

EXAMPLE 5.5

Calculating the Present Value of a Savings Bond

You’re on vacation in a rather remote part of Florida and see an advertisement

stat-ing that if you take a sales tour of some condominiums “you will be given $100 just

for taking the tour.” However, the $100 that you get is in the form of a savings bond

that will not pay you the $100 for 10 years What is the present value of $100 to be

received 10 years from today if your discount rate is 6 percent?

466 Part 4 • Capital Structure and Dividend Policy

12-9. (EBIT-EPS analysis) A group of retired college professors has decided to form

a small manufacturing corporation The company will produce a full line of tional office furniture The investors have proposed two financing plans Plan A is an all-common-equity alternative Under this agreement, 1 million common shares will

tradi-be sold to net the firm $20 per share Plan B involves the use of financial leverage

A debt issue with a 20-year maturity period will be privately placed The debt issue will carry an interest rate of 10 percent, and the principal borrowed will amount to

$6 million The marginal corporate tax rate is 50 percent.

a Find the EBIT indifference level associated with the two financing proposals.

b Prepare a pro forma income statement that proves EPS will be the same gardless of the plan chosen at the EBIT level found in part (a).

re-c Prepare an EBIT-EPS analysis chart for this situation.

d If a detailed financial analysis projects that long-term EBIT will always be close

to $2.4 million annually, which plan will provide for the higher EPS?

12-10. (Assessing leverage use) Financial data for three corporations are displayed here.

Debt ratio 20% 25% 40% 20%

Times interest earned 8 times 10 times 7 times 9 times Price/earnings ratio 9 times 11 times 6 times 10 times

a Which firm appears to be excessively leveraged?

b Which firm appears to be employing financial leverage to the most ate degree?

appropri-c What explanation can you provide for the higher price/earnings ratio enjoyed

by firm B as compared with firm A?

Mini Cases

These Mini Cases are available in My Finance Lab

1. Imagine that you were a new CFO of Beily Inc., a children’s bicycle manufacturer

The president, Mr Zhao, started the business 2 years ago The firm manufactures two types of products, bicycles for girls and bicycles for boys However, the two products have the same prices and costs structures, the only differences are the colors and designs Recently, the president has started to focus more on the financial aspects

of managing the business Mr Zhao has set up a meeting for next week with you, to discuss matters such as the business and financial risks faced by the company.

Accordingly, you are asked to prepare an analysis to assist his future ment decisions As a first step in the work, you are provided the following informa- tion regarding the company according to the past financial data:

manage-Output level 25,000 units Operating assets RMB 2,000,000 Operating asset turnover 5 times Return on operating assets 45%

Degree of operating leverage 5 times Interest expense RMB 300,000 Tax rate 25%

As the next step, you are required to determine the break-even point in units of output for the company and report the result to Mr Zhao You are going to prepare

an analytical income statement for the company This statement will also be useful

M12_KEOW5135_09_GE_C12.indd 466 06/05/16 5:49 PM

A Complete Support Package for the Student and Instructor

MyFinanceLab

This fully integrated online homework system gives students the hands-on tice and tutorial help they need to learn finance efficiently Ample opportunities for online practice and assessment in MyFinanceLab are seamlessly integrated into each chapter For more details, see the inside front cover

prac-Instructor’s Resource Center

This password-protected site, accessible at http://www.pearsonglobaleditions.com/

Keown, hosts all of the instructor resources that follow Instructors should click on

the “IRC Help Center” link for easy-to-follow instructions on getting access or may contact their sales representative for further information

Test Bank

This online Test Bank, prepared by Rodrigo Hernandez of Radford University, vides more than 1,600 multiple-choice, true/false, and short-answer questions with complete and detailed answers The online Test Bank is designed for use with the TestGen-EQ test-generating software This computerized package allows instruc-tors to custom design, save, and generate classroom tests The test program permits instructors to edit, add, or delete questions from the Test Bank; analyze test results;

pro-and organize a database of tests pro-and student results This software allows for greater flexibility and ease of use It provides many options for organizing and displaying tests, along with a search and sort feature

Instructor’s Manual with Solutions

Written by the authors and updated by Mary Schranz, the Instructor’s Manual follows the textbook’s organization and represents a continued effort to serve the teacher’s goal of being effective in the classroom Each chapter contains a chapter orientation, answers to end-of-chapter review questions, and solutions to end-of-chapter study problems

The Instructor’s Manual is available electronically, and instructors can download

it from the Instructor’s Resource Center by visiting http://www.pearsonglobaleditions

.com/Keown.

The PowerPoint Lecture Presentation

This lecture presentation tool, prepared by Sonya Britt of Kansas State University, provides the instructor with individual lecture outlines to accompany the text The slides include many of the figures and tables from the text These lecture notes can

be used as is, or instructors can easily modify them to reflect specific presentation needs

Excel Spreadsheets

Created by the authors, these spreadsheets correspond to end-of-chapter problems from the text This student resource is available on MyFinanceLab

We gratefully acknowledge the assistance, support, and encouragement of those

indi-viduals who have contributed to Foundations of Finance Specifically, we wish to

rec-ognize the very helpful insights provided by many of our colleagues For this edition,

we are especially grateful to Mary Schranz, formerly of the University of Wisconsin,

Madison, who performed an incredibly detailed accuracy review We are also

indebted to many other professionals for their careful reviews and helpful comments:

Haseeb Ahmed, Johnson C Smith University

Joan Anderssen, Arapahoe Community CollegeChris Armstrong, Draughons Junior College

Curtis Bacon, Southern Oregon University

Deb Bauer, University of OregonPat Bernson, County College of Morris

Ed Boyer, Temple UniversityJoe Brocato, Tarleton State University

Joseph Brum, Fayetteville Technical Community College

Lawrence Byerly, Thomas More College

Juan R Castro, LeTourneau University

Janice Caudill, Auburn UniversityTing-Heng Chu, East Tennessee State University

David Daglio, Newbury CollegeJulie Dahlquist, University of Texas

at San AntonioDavid Darst, Central Ohio Technical College

Maria de Boyrie, New Mexico State University

Kate Demarest, Carroll Community College

Khaled Elkhal, University of Southern Indiana

Cheri Etling, University of TampaRobert W Everett, Lock Haven University

Cheryl Fetterman, Cape Fear Community CollegeDavid R Fewings, Western Washington University

Dr Charles Gahala, Benedictine University

Harry Gallatin, Indiana State University

Deborah Giarusso, University of Northern Iowa

Gregory Goussak, University of Nevada, Las Vegas

Lori Grady, Bucks County Community College

Ed Graham, University of North Carolina, Wilmington

Barry Greenberg, Webster University

Gary Greer, University of Houston Downtown

Indra Guertler, Simmons CollegeBruce Hadburg, University of TampaThomas Hiebert, University of North Carolina, CharlotteMarlin Jensen, Auburn UniversityJohn Kachurick, Misericordia University

Okan Kavuncu, University of California at Santa CruzGary Kayakachoian, The University

of Rhode IslandDavid F Kern, Arkansas State University

Brian Kluger, University of Cincinnati

Lynn Phillips Kugele, University of Mississippi

Mary LaPann, Adirondack Community CollegeCarlos Liard-Muriente, Central Connecticut State UniversityChristopher Liberty, College of Saint Rose, Empire State CollegeLynda Livingston, University of Puget Sound

We also thank our friends at Pearson They are a great group of folks We offer our personal expression of appreciation to Vice President of Business Publishing Donna Battista, who provided the leadership and direction to this project She is the best, and she settles for nothing less than perfection—thanks, Donna We would also like to thank Kate Fernandes, our finance editor Kate is full of energy and drive with amazing insights and intuition about what makes a great book Additionally, Kathryn Dinovo, our program manager, helped us develop new technology— videos and animations—for this edition We would also like to thank Meredith Gertz, our project manager, who guided us through the writing and production processes

Meredith kept us on schedule while maintaining extremely high quality Our thanks also go to Heidi Allgair of Cenveo Publisher Services, who served as the project man-ager and did a superb job Even more, she was fun to work with, always keeping us

on task Miguel Leonarte, who worked on MyFinanceLab, also deserves a word of thanks for making MyFinanceLab flow so seamlessly with the book He has contin-ued to refine and improve MyFinanceLab, and as a result of his efforts, it has become

a learning tool without equal We also thank Melissa Honig, our media producer, who did a great job of making sure we are on the cutting edge in terms of Web appli-cations and offerings

As a final word, we express our sincere thanks to those who are using Foundations

of Finance in the classroom We thank you for making us a part of your teaching–

learning team Please feel free to contact any member of the author team should you have questions or needs

Anna McAleer, Arcadia UniversityRobert Meyer, Parkland CollegeRonald Moy, St John’s UniversityElisa Muresan, Long Island University

Michael Nugent, Stony Brook University

Tony Plath, University of North Carolina at Charlotte

Anthony Pondillo, Siena CollegeWalter Purvis, Coastal Carolina Community College

Emil Radosevich, Central New Mexico Community CollegeDeana Ray, Forsyth Technical Community CollegeClarence Rose, Radford University

Ahmad Salam, Widener UniversityMary Schranz, University of Wisconsin, Madison (retired)Jeffrey Schultz, Christian Brothers University

Thomas W Secrest, Coastal Carolina UniversityKen Shakoori, California State University, BakersfieldMichael Slates, Bowling Green State University

Suresh Srivastava, University of Alaska, Anchorage

Maurry Tamarkin, Clark UniversityFang Wang, West Virginia

UniversityPaul Warrick, Westwood CollegeJill Wetmore, Saginaw Valley State University

Kevin Yost, Auburn UniversityJingxue Yuan, Texas Tech University

Mengxin Zhao, Bentley College

Global Edition Acknowledgments

We gratefully acknowledge the contributions of those individuals who worked with

us on the Foundations of Finance, Global Edition We are also indebted to many

other professionals for their careful reviews and helpful comments:

Contributors

Nino Davitaya, University of Georgia

Hisham Farag, University of

BirminghamKatharina Fellnhofer, Lappeenranta

University of TechnologyCatherine Lions, Umea School of

Business and EconomicsBiljana Pesalj, Rotterdam University of

Applied SciencesJon Snorri Snorrason, Bifröst University

Andrejs Cirjevskis, Riga International School of Economics and Business Administration

Apple Computer (AAPL) ignited the personal computer revolution in the

1970s with the Apple II and reinvented the personal computer in the 1980s with the Macintosh But by 1997, it looked like it might be nearing the end for Apple Mac users were on the decline, and the company didn’t seem to be headed

in any real direction It was at that point that Steve Jobs reappeared, taking back his old job as CEO of Apple, the company he cofounded in 1976 To say the least, things began to change In fact, 18 years later, in 2015, the price of Apple’s common stock climbed by 225-fold!

How did Apple accomplish this? The company did it by going back to what it does best, which is to produce products that make the optimal trade-off among ease of use, complexity, and features Apple took its special skills and applied them to more than just computers, introducing new products such as the iPod, iTunes, the sleek iMac, the MacBook Air, the iPod Touch, and the iPhone along with its unlimited

“apps.” Although all these products have done well, the success of the iPod has been truly amazing Between the introduction of the iPod in October 2001 and the begin-ning of 2005, Apple sold more than 6 million of the devices Then, in 2004, it came out with the iPod Mini, about the length and width of a business card, which has also

CHAPTER

1 An Introduction to the Foundations of

Financial Management

Learning Objectives

LO 1 Identify the goal of the firm The Goal of the Firm

LO 2 Understand the basic principles of finance,

their importance, and the importance of ethics and trust.

Five Principles That Form the Foundations of Finance

LO 3 Describe the role of finance in business The Role of Finance in Business

LO 4 Distinguish among the different legal forms

been a huge success, particularly among

women How successful has this new

product been? By 2004, Apple was selling

more iPods than its signature Macintosh

desktop and notebook computers

How do you follow up on the success

of the iPod? You keep improving your

products, and you keep developing and

introducing new products that

consum-ers want—the iPhone With this in mind,

in October 2014, Apple unveiled its

iPhone 6 and 6 Plus, selling over 10

mil-lion phones in the first week In effect,

Apple seems to have a never-ending

sup-ply of new, exciting products that we all

want Then in April 2015, Apple introduced the Apple Watch, and it is now

consider-ing introducconsider-ing an Apple Car by 2020

How did Apple make the decision to introduce the original iPod and now the

iPad? The answer is by identifying a customer need, combined with sound financial

management Financial management deals with the maintenance and creation of

economic value or wealth by focusing on decision making with an eye toward

creat-ing wealth This text deals with financial decisions such as when to introduce a new

product, when to invest in new assets, when to replace existing assets, when to

bor-row from banks, when to sell stocks or bonds, when to extend credit to a customer,

and how much cash and inventory to maintain All of these aspects of financial

man-agement were factors in Apple’s decision to introduce and continuously improve the

iPod, iPhone, and iPad, and the end result is having a major financial impact on Apple

In this chapter, we lay the foundation for the entire book by explaining the key

goal that guides financial decision making: maximizing shareholder wealth From

there we introduce the thread that ties everything together: the five basic principles

of finance Finally, we discuss the legal forms of business We close the chapter with a

brief look at what has led to the rise in multinational corporations

The Goal of the Firm

The fundamental goal of a business is to create value for the company’s owners (i.e.,

its shareholders) This goal is frequently stated as “maximization of shareholder

wealth.” Thus, the goal of the financial manager is to create wealth for the

sharehold-ers by making decisions that will maximize the price of the existing common stock

Not only does this goal directly benefit the shareholders of the company, but it also

provides benefits to society as scarce resources are directed to their most productive

use by businesses competing to create wealth

We have chosen maximization of shareholder wealth—that is, maximizing the

market value of the existing shareholders’ common stock—because all financial

deci-sions ultimately affect the firm’s stock price Investors react to poor investment or

dividend decisions by causing the total value of the firm’s stock to fall, and they react

to good decisions by pushing up the price of the stock In effect, under this goal,

good decisions are those that create wealth for the shareholder

27

firm.

Obviously, some serious practical problems arise when we use changes in the value of the firm’s stock to evaluate financial decisions Many things affect stock prices; to attempt to identify a reaction to a particular financial decision would sim-ply be impossible, but fortunately that is unnecessary To employ this goal, we need not consider every stock price change to be a market interpretation of the worth of our decisions Other factors, such as changes in the economy, also affect stock prices

What we do focus on is the effect that our decision should have on the stock price if

everything else were held constant The market price of the firm’s stock reflects the value of the firm as seen by its owners and takes into account the complexities and complications of the real-world risk As we follow this goal throughout our discus-sions, we must keep in mind one more question: Who exactly are the shareholders?

The answer: Shareholders are the legal owners of the firm

Concept Check

1 What is the goal of the firm?

2 How would you apply this goal in practice?

Five Principles That Form the Foundations

of Finance

To the first-time student of finance, the subject matter may seem like a collection of unrelated decision rules This impression could not be further from the truth In fact, our decision rules, and the logic that underlies them, spring from five simple princi-ples that do not require knowledge of finance to understand These five principles guide the financial manager in the creation of value for the firm’s owners (the stock-holders)

As you will see, although it is not necessary to understand finance to understand these principles, it is necessary to understand these principles in order to understand finance These principles may at first appear simple or even trivial, but they provide the driving force behind all that follows, weaving together the concepts and tech-niques presented in this text, and thereby allowing us to focus on the logic underly-ing the practice of financial management Now let’s introduce the five principles

Principle 1: Cash Flow Is What Matters

You probably recall from your accounting classes that a company’s profits can differ dramatically from its cash flows, which we will review in Chapter 3 But for now understand that cash flows, not profits, represent money that can be spent

Consequently, it is cash flow, not profits, that determines the value of a business For this reason when we analyze the consequences of a managerial decision, we focus on the resulting cash flows, not profits

In the movie industry, there is a big difference between accounting profits and cash flow Many a movie is crowned a success and brings in plenty of cash flow for the studio but doesn’t produce a profit Even some of the most successful box office

hits—Forrest Gump, Coming to America, Batman, My Big Fat Greek Wedding, and the TV series Babylon 5—realized no accounting profits at all after accounting for various

movie studio costs That’s because “Hollywood Accounting” allows for overhead costs not associated with the movie to be added on to the true cost of the movie In

fact, the movie Harry Potter and the Order of the Phoenix, which grossed almost $1 lion worldwide, actually lost $167 million according to the accountants Was Harry Potter and the Order of the Phoenix a successful movie? It certainly was—in fact, it was

bil-the 27th highest grossing film of all time Without question, it produced cash, but it didn’t make any profits

principles of finance, their importance, and the

importance of ethics and trust.

1principle

We need to make another important point about cash flows Recall from your

economics classes that we should always look at marginal, or incremental, cash

flows when making a financial decision The incremental cash flow to the company

as a whole is the difference between the cash flows the company will produce both with and

without the investment it’s thinking about making To understand this concept, let’s think

about the incremental cash flows of the movie Frozen Not only did Disney make

money on this movie, but it also made an awful lot of money on merchandise from

the movie While Anna and Elsa pulled in an incredible $1.3 billion at the box office,

sales of Frozen toys, clothing, and games along with the soundtrack brought in about

that same amount With a Broadway version under development and the possibility

of a sequel under way, Disney is going to be singing “Let It Go” all the way to the

bank

Principle 2: Money Has a Time Value

Perhaps the most fundamental principle of finance is that money has a “time” value

Very simply, a dollar received today is more valuable than a dollar received 1 year

from now because we can invest the dollar we have today to earn interest so that at

the end of 1 year we will have more than one dollar

For example, suppose you have a choice of receiving $1,000 either today or 1 year

from now If you decide to receive it a year from now, you will have passed up the

opportunity to earn a year’s interest on the money Economists would say you

suf-fered an “opportunity loss” or an “opportunity cost.” The cost is the interest you

could have earned on the $1,000 if you had invested it for 1 year The concept of

opportunity costs is fundamental to the study of finance and economics Very simply,

the opportunity cost of any choice you make is the highest-valued alternative that you

had to give up when you made the choice So if you loan money to your brother at no

interest, money that otherwise would have been loaned to a friend (who is equally

likely to repay you) for 8 percent interest, then the opportunity cost of making the

loan to your brother is 8 percent

In the study of finance, we focus on the creation and measurement of value To

measure value, we use the concept of the time value of money to bring the future

benefits and costs of a project, measured by its cash flows, back to the present Then,

if the benefits or cash inflows outweigh the costs, the project creates wealth and

should be accepted; if the costs or cash outflows outweigh the benefits or cash

inflows, the project destroys wealth and should be rejected Without recognizing the

existence of the time value of money, it is impossible to evaluate projects with future

benefits and costs in a meaningful way

Principle 3: risk requires a reward

Even the novice investor knows there are an unlimited number of investment

alter-natives to consider But without exception, investors will not invest if they do not

expect to receive a return on their investment They will want a return that satisfies

two requirements:

would not at least pay them something for delaying consumption? They won’t—

even if there is no risk In fact, investors will want to receive at least the same

return that is available for risk-free investments, such as the rate of return being

earned on U.S government securities

risky investments are less attractive—unless they offer the prospect of higher

returns That said, the more unsure people are about how an investment will

per-form, the higher the return they will demand for making that investment So, if

you are trying to persuade investors to put money into a risky venture you are

pursuing, you will have to offer them a higher expected rate of return

2principle

3principle

incremental cash flow the difference between the cash flows a company will produce both with and without the investment it is thinking about making.

opportunity cost the cost of making

a choice in terms of the next best alternative that must be foregone.

Figure 1-1 depicts the basic notion that an investor’s rate of return should equal

a rate of return for delaying consumption plus an additional return for assuming risk For example, if you have $5,000 to invest and are considering either buying stock in Apple (AAPL) or investing in a new biotech startup firm that has no past record of success, you would want the startup investment to offer the prospect of

a higher expected rate of return than the investment in an established company like Apple

Notice that we keep referring to the expected return rather than the actual return

As investors, we have expectations about what returns our investments will earn

However, we can’t know for certain what they will be For example, if investors could

have seen into the future, no one would have bought stock in Vascular Biogenics (VBLT), an Israeli-based clinical-stage biopharmaceutical company, on February 19,

2015 Why? Because on that day the company reported that Phase 2 trials of one of its drugs aimed at psoriasis and ulcerative colitis failed to meet its primary endpoints

The result was that, within minutes of the announcement, the company’s stock price dropped by a whopping 65 percent

The risk–return relationship will be a key concept as we value stocks, bonds, and proposed new investment projects throughout this text We will also spend some time determining how to measure risk Interestingly, much of the work for which the

1990 Nobel Prize for economics was awarded centered on the relationship depicted

in the graph in Figure 1-1 and how to measure risk Both the graph and the risk–

return relationship it depicts will reappear often in our study of finance

Principle 4: Market Prices Are Generally Right

To understand how securities such as bonds and stocks are valued or priced in the financial markets, it is necessary to understand the concept of an efficient market An

efficient market is one in which the prices of the assets traded in that market fully reflect

all available information at any instant in time.

Security markets such as the stock and bond markets are particularly important

to our study of finance because these markets are the place where firms can go to raise money to finance their investments Whether a security market such as the New York Stock Exchange (NYSE) is efficient depends on the speed with which newly released information is impounded into prices Specifically, an efficient stock market is characterized by a large number of profit-driven individuals who act very quickly by buying (or selling) shares of stock in response to the release of new information

If you are wondering just how vigilant investors in the stock market are in watching for good and bad news, consider the following set of events While Nike

FIGURE 1-1 The Risk–Return Trade-off

Additional expected return for taking on added risk

Risk

Expected return for delaying consumption

4principle

efficient market a market in which

the prices of securities at any instant in

time fully reflect all publicly available

information about the securities and

their actual public values.

(NKE) CEO William Perez flew aboard the company’s Gulfstream jet one day in

November 2005, traders on the ground sold off a significant amount of Nike’s

stock Why? Because the plane’s landing gear was malfunctioning, and they were

watching TV coverage of the event! Before Perez landed safely, Nike’s stock

dropped 1.4 percent Once Perez’s plane landed, Nike’s stock price immediately

bounced back This example illustrates that in the financial market there are

ever-vigilant investors who are looking to act even in the anticipation of the release of

new information

Another example of the speed with which stock prices react to new information

deals with Disney Beginning with Toy Story in 1995, Disney (DIS) was on a roll,

mak-ing one hit after another, includmak-ing Monsters, Inc., Findmak-ing Nemo, the Pirates of the

Caribbean series, The Incredibles, the Ironman series, and Frozen In spite of all this

suc-cess, in 2014, the hopes for Guardians of the Galaxy, based on a relatively unknown

Marvel comic book series starring a tree and a talking raccoon among other

charac-ters, weren’t very high However, the movie’s opening weekend receipts were

amaz-ing: While it was projected to gross less than $70 million worldwide, it actually

grossed over $160 million and became the top grossing movie of 2014 How did the

stock market respond to the unexpected box office reaction during the movie’s

open-ing weekend? On the Monday followopen-ing the openopen-ing weekend, Disney stock opened

over 2 percent higher Apparently, the news of the surprisingly strong box office

receipts was reflected in Disney’s opening stock price, even before it traded! The

same speed in the market reaction to new information also happened on February

25, 2015, when it was learned that 60 Minutes would air a potentially damaging story

on Lumber Liquidators later that week As a result, Lumber Liquidators’ stock price

dropped by 25 percent even before anyone knew what the story was going to be

about—in effect, it dropped before the news After the 60 Minutes report that

out-lined health and safety concerns with its laminated flooring actually aired on Sunday

evening, Lumber Liquidators opened another 25 percent down

The key learning point here is the following: Stock market prices are a useful

barometer of the value of a firm Specifically, managers can expect their company’s

share prices to respond quickly to investors’ assessment of their decisions On the

one hand, if investors on the whole agree that the decision is a good one that creates

value, then they will push up the price of the firm’s stock to reflect that added value

On the other hand, if investors feel that a decision is bad for share prices, then the

firm’s share value will be driven down

Unfortunately, this principle doesn’t always work perfectly in the real world

You just need to look at the housing price bubble that helped bring on the

eco-nomic downturn in 2008–2009 to realize that prices and value don’t always move

in lockstep Like it or not, the psychological biases of individuals impact decision

making, and as a result, our decision-making process is not always rational

Behavioral finance considers this type of behavior and takes what we already know

about financial decision making and adds in human behavior with all its apparent

irrationality

We’ll try and point out the impact of human behavior on decisions throughout

our study But understand that the field of behavioral finance is a work in progress—

we understand only a small portion of what may be going on We can say, however,

that behavioral biases have an impact on our financial decisions As an example,

people tend to be overconfident and many times mistake luck for skill As Robert

Shiller, a well-known economics professor at Yale, put it, “people think they know

and understanding, and forecasting the future Because they have confidence in their

valuation estimates, they may take on more risk than they should These behavioral

biases impact everything in finance, ranging from making investment analyses to

analyzing new projects to forecasting the future

1 See Robert J Shiller, Irrational Exuberance (New York: Broadway Books, 2000), p 166.

Principle 5: Conflicts of Interest Cause Agency Problems

Throughout this book we will describe how to make financial decisions that increase the value of a firm’s shares However, managers do not always follow through with these decisions Often they make decisions that actually lead to a decrease in the value of the firm’s shares When this happens, it is frequently because the managers’

own interests are best served by ignoring shareholder interests In other words, there

is a conflict of interest between what is best for the managers and what is best for the stockholders For example, shutting down an unprofitable plant may be in the best interests of the firm’s stockholders, but in so doing the managers will find themselves out of a job or having to transfer to a different job This very clear conflict of interest might lead the management of the plant to continue running the plant at a loss

Conflicts of interest lead to what economists describe as an agency cost or

agency problem That is, managers are the agents of the firm’s stockholders (the

owners), and if the agents do not act in the best interests of their principal, this leads

to an agency cost Although the goal of the firm is to maximize shareholder value, in

reality the agency problem may interfere with implementation of this goal The agency problem results from the separation of the management and ownership of the firm

For example, a large firm may be run by professional managers or agents who have little or no ownership in the firm Because of this separation between decision mak-ers and owners, managers may make decisions that are not in line with the goal of maximizing shareholder wealth They may approach work less energetically and attempt to benefit themselves in terms of salary and perquisites at the expense of shareholders

Managers might also avoid any projects that have risk associated with them—

even if they are great projects with huge potential returns and a small chance of ure Why is this so? Because if the project isn’t successful, these agents of the share-holders may lose their jobs

fail-Agency problems also contributed to our recent financial crisis, with some gage brokers being paid to find borrowers The brokers would then make the loan and sell the mortgage to someone else Because they didn’t hold the mortgage but only created it, they didn’t care about the quality of the mortgage In effect, they wrote mortgages when the borrower had a low chance of being able to pay off the mortgage because they got paid per mortgage and then sold the mortgage to some-one else almost immediately There was no incentive to screen for the quality of the borrower, and as a result both the borrower who was misled into thinking he could afford the mortgage and the holder of the mortgage were hurt

mort-The costs associated with the agency problem are difficult to measure, but sionally we see the problem’s effect in the marketplace If the market feels manage-ment is damaging shareholder wealth, removal of that management may cause a positive reaction in stock price For example, on the announcement of the death of Roy Farmer, the CEO of Farmer Brothers (FARM), a seller of coffee-related products, Farmer Brothers’ stock price rose about 28 percent Generally, the tragic loss of a company’s top executive raises concerns over a leadership void, causing the share price to drop; in the case of Farmer Brothers, however, investors thought a change in management would have a positive impact on the company

occa-If the firm’s management works for the owners, who are the shareholders, why doesn’t the management get fired if it doesn’t act in the shareholders’ best interest?

In theory, the shareholders pick the corporate board of directors, and the board of directors in turn picks the management Unfortunately, in reality the system fre-quently works the other way around Management selects the board of director nominees and then distributes the ballots In effect, shareholders are generally offered a slate of nominees selected by the management The end result is that man-agement effectively selects the directors, who then may have more allegiance to managers than to shareholders This, in turn, sets up the potential for agency prob-lems, with the board of directors not monitoring managers on behalf of the share-holders as it should

principle5

agency problem problems and

conflicts resulting from the separation

of the management and ownership of

the firm.

The root cause of agency problems is conflict of interest Whenever such conflicts

exist in business, individuals may do what is in their own rather than the

organiza-tion’s best interests For example, in 2000 Edgerrin James was a running back for the

Indianapolis Colts and was told by his coach to get a first down and then fall down

That way the Colts wouldn’t be accused of running up the score against a team they

were already beating badly However, since James’s contract included incentive

pay-ments associated with rushing yards and touchdowns, he acted in his own self-

interest and ran for a touchdown on the very next play

We will spend considerable time discussing monitoring managers and the

meth-ods used to align their interests with those of shareholders As an example, managers

can be monitored by rating agencies and by auditing financial statements, and

com-pensation packages may be used to align the interests of managers and shareholders

Additionally, the interests of managers and shareholders can be aligned by

establish-ing management stock options, bonuses, and perquisites that are directly tied to how

closely managers’ decisions coincide with the interests of shareholders In other

words, what is good for shareholders must also be good for managers If that is not

the case, managers will make decisions in their best interest rather than maximizing

shareholder wealth

The Global Financial Crisis

Beginning in 2007, the United States experienced its most severe financial crisis since

the Great Depression of the 1930s As a result, some financial institutions collapsed

while the government bailed others out, unemployment skyrocketed, the stock

market plummeted, and the United States entered into a recession Although the

recession is now officially over, many Americans still feel the lingering effects of the

financial crisis from lost wages resulting from high unemployment, along with a

dra-matic rise in our country’s debt Europe also faced a financial crisis of its own Many

members of the European Union (EU) experienced severe budget problems,

includ-ing Greece, Italy, Ireland, Portugal, and Spain These nations have all had problems

balancing their budgets and repaying their government loans

Although many factors contributed to the financial crisis, the most immediate

cause has been attributed to the collapse of the real estate market in the United States

and the resulting real estate loan (mortgage) defaults The focus of the loan defaults

has been on what are commonly referred to as subprime loans These are loans made

to borrowers whose ability to repay them is highly doubtful When the market for

real estate began to falter in 2006, many of the homebuyers with subprime mortgages

began to default As the economy contracted during the recession, people lost their

jobs and could no longer make their mortgage loan payments, resulting in even more

defaults

To complicate the problem, most real estate mortgages were packaged in

portfo-lios and resold to investors around the world This process of packaging mortgages

is called securitization Basically, securitization is a very useful tool for increasing the

supply of new money that can be lent to new homebuyers Here’s how mortgages

are securitized: First, homebuyers borrow money by taking out a mortgage to

finance a home purchase The lender, generally a bank, savings and loan, or

mort-gage broker that made the loan, then sells the mortmort-gage to another firm or financial

institution that pools together a portfolio of many different mortgages The purchase

of the pool of mortgages is financed through the sale of securities (called

mortgage-backed securities, or MBS) that are sold to investors who can hold them as an

invest-ment or resell them to other investors This process allows the mortgage bank or

other financial institution that made the original mortgage loan to get its money

back out of the loan and lend it to someone else Thus, securitization provides

liquid-ity to the mortgage market and makes it possible for banks to loan more money to

homebuyers

Okay, so what’s the catch? As long as lenders properly screen the mortgages to

make sure the borrowers are willing and able to repay their home loans and real

estate values remain higher than the amount owed, everything works fine

However, if lenders make loans to individuals who really cannot afford to make the payments and real estate prices drop precipitously, as they began to do in 2006, problems will arise and many mortgages (especially those in which the amount of the loan was a very high percentage of the property value) will be “under water.”

That is, the homeowner will owe more than the home is worth When this occurs homeowners may start to default on their mortgage loans This is especially true when the economy goes into a recession and people lose their jobs and, correspond-ingly, the ability to make their mortgage payments This was the scenario in 2006

In essence, 2006 brought a perfect storm of bad loans, falling housing prices, and a contracting economy

Where are we now? As of this writing, in 2015, the recession is officially over, having ended in 2009; however, despite this pronouncement there is evidence that the economy is still not back to normal Although the unemployment rate has gone down, the unemployment rate may not accurately reflect those job seekers who have given up and are no longer seeking employment, and it may not reflect what has become known as underemployment, whereby individuals are taking jobs but these jobs do not take advantage of the individuals’ employment creden-tials (for example, college professors driving taxi cabs) Europe still faces economic problems of its own, with Greece’s economy in crisis with an unemployment rate over 25 percent, while unemployment in Spain and Italy is topping 22 percent and

12 percent, respectively

Avoiding Financial Crisis—Back to the Principles

Four significant economic events that have occurred during the last decade all point

to the importance of keeping our eye closely affixed to the five principles of finance:

the dot-com bubble; the accounting scandals headlined by Enron, WorldCom, and Bernie Madoff; the housing bubble; and, finally, the recent economic crisis

Specifically, the problems that firms encounter in times of crisis are often brought on and made worse by not paying close attention to the foundational principles of finance To illustrate, consider the following:

◆ Forgetting Principle 1: Cash Flow Is What Matters (Focusing on earnings instead

others at the turn of the 21st century was a direct result of managerial efforts to manage the firm’s reported earnings to the detriment of the firm’s cash flows The belief in the importance of current period earnings as the most critical determi-nant of the market valuation of the firm’s shares led some firms to sacrifice future cash flows in order to maintain the illusion of high and growing earnings

◆ Forgetting Principle 2: Money Has a Time Value (Focusing on the short run)

When trying to put in place a system that would align the interests of managers and shareholders, many firms tied managerial compensation to short-run perfor-mance Consequently, in many firms the focus shifted from what was best in the long run to what was best in the short run

◆ Forgetting Principle 3: Risk Requires a Reward (Excessive risk taking due to

under-estimated the real risks that their decisions entailed This underestimation of the underlying riskiness of their decisions led managers to borrow excessively This excessive use of borrowed money (or financial leverage) led to financial disaster and bankruptcy for many firms as the economy slipped into recession Moreover, the financial crisis was exacerbated by the fact that often companies simply didn’t understand how much risk they were taking on For example, AIG, the giant insurance company that the government bailed out, was involved in investments whose value is based on the price of oil in 50 years Let’s face it, no one knows what the price of oil will be in a half a century—being involved in this type of investment is blind risk

◆ Forgetting Principle 4: Market Prices Are Generally Right (Ignoring the efficiency

the last decade and entered into investment strategies that presupposed that

security prices could be predicted Many of these same firms borrowed heavily

in an effort to boost their returns and later discovered that security markets were

a lot smarter than they thought and consequently realized huge losses on their

highly leveraged portfolios

◆ Forgetting Principle 5: Conflicts of Interest Cause Agency Problems (Unchecked

agency problems in the subprime housing market and problems with executive

our recent financial crisis, and much of the subprime lending crisis had its roots in

the agency problem As mentioned earlier, mortgage brokers weren’t concerned

with whether or not the borrower could handle the mortgage because they got

paid on the number of mortgages they made, not the quality of the mortgages

The banks didn’t care about the quality of the borrowers either because they had

no intention of holding the mortgages; instead, they pooled the mortgages and

sold them to unsuspecting investors In effect, much of the subprime lending

cri-sis was a result of both an unchecked conflict of interest and an ethical lapse

Executive compensation in the United States is dominated by performance-based

compensation in the form of stock options and grants The use of these forms of

com-pensation over the last decade in the face of one of the longest bull markets in history

has resulted in tremendous growth in executive compensation The motivations

behind these methods of compensation are primarily tied to a desire to make

manag-ers behave like stockholdmanag-ers (ownmanag-ers) Unfortunately, this practice has resulted in

pay for nonperformance in many cases and a feeling among the general public that

executive compensation is excessive We are reminded again that solving the

principal–agent problem is not easy to do, but it has to be done!

The Essential Elements of Ethics and Trust

Though not one of the five principles of finance, ethics and trust are essential

ele-ments of the business world In fact, without ethics and trust, nothing works This

statement could be applied to almost everything in life Virtually everything we do

involves some dependence on others Although businesses frequently try to describe

the rights and obligations of their dealings with others using contracts, it is

impossi-ble to write a perfect contract Consequently, business dealings between people and

firms ultimately depend on the willingness of the parties to trust one another

Ethics or, rather, a lack of ethics in finance is a recurring theme in the news

Financial scandals at Enron, WorldCom, Arthur Andersen, and Bernard L Madoff

Investment Securities demonstrate that ethical lapses are not forgiven in the business

world Not only is acting in an ethical manner morally correct, it is a necessary

ingre-dient to long-term business and personal success

Looking back at the recent financial crisis, we see that a good part of the cause

finds its roots in ethical failures in the subprime mortgage market Ethical behavior is

easily defined It’s simply “doing the right thing.” But what is the right thing? For

example, Bristol-Myers Squibb (BMY) gives away heart medication to people who

can’t afford it Clearly, the firm’s management feels this is the socially responsible

and right thing to do But is it? Should companies give away money and products, or

should they leave such acts of benevolence to the firm’s shareholders? Perhaps the

shareholders should decide if they personally want to donate some of their wealth to

worthy causes

As is true of most ethical questions, the dilemma posited above has no clear-cut

solution We acknowledge that people have a right to disagree about what “doing

the right thing” means and that each of us has his or her personal set of values These

values form the basis for what we think is right and wrong Moreover, every society

adopts a set of rules or laws that prescribe what it believes constitutes “doing the

right thing.” In a sense, we can think of laws as a set of rules that reflect the values of

a society as a whole

You might ask yourself, “As long as I’m not breaking society’s laws, why should I care about ethics?” The answer to this question lies in consequences Everyone makes errors of judgment in business, which is to be expected in an uncertain world But ethi-cal errors are different Even if they don’t result in anyone going to jail, they tend to end careers and thereby terminate future opportunities Why? Because unethical behavior destroys trust, and businesses cannot function without a certain degree of trust

Concept Check

1 According to Principle 3, how do investors decide where to invest their money?

2 What is an efficient market?

3 What is the agency problem, and why does it occur?

4 Why are ethics and trust important in business?

The Role of Finance in Business

Finance is the study of how people and businesses evaluate investments and raise capital to fund them Our interpretation of an investment is quite broad When Apple designed its Apple Watch, it was clearly making a long-term investment The firm had to devote considerable expenses to designing, producing, and marketing the device with the hope that it would eventually become indispensable to everyone

Similarly, Apple is making an investment decision whenever it hires a fresh new graduate, knowing that it will be paying a salary for at least 6 months before the employee will have much to contribute

Thus, the study of finance addresses three basic types of issues:

1 What long-term investments should the firm undertake? This area of finance is

generally referred to as capital budgeting.

2 How should the firm raise money to fund these investments? The firm’s funding

choices are generally referred to as capital structure decisions.

3 How can the firm best manage its cash flows as they arise in its day-to-day

operations? This area of finance is generally referred to as working capital

management

We’ll be looking at each of these three areas of business finance—capital ing, capital structure, and working capital management—in the chapters ahead

budget-Why Study Finance?

Even if you’re not planning a career in finance, a working knowledge of finance will take you far in both your personal and professional life

Those interested in management will need to study topics such as strategic ning, personnel, organizational behavior, and human relations, all of which involve spending money today in the hopes of generating more money in the future For example, it has been estimated that it would cost Apple over $1 billion to develop a new electric car, and that doesn’t guarantee the car would be a success After all, GM made a strategic decision to introduce an electric car and invested $740 million to produce the Chevy Volt, only to find car buyers balking at the $40,000 sticker price

plan-Similarly, marketing majors need to understand and decide how aggressively to price products, the amount to spend on advertising, and what media to use for those ads Since aggressive marketing today costs money but allows firms to reap rewards

in the future, it should be viewed as an investment that the firm needs to finance

Production and operations management majors need to understand how best to

finance in business.

capital budgeting the decision-

making process with respect to

investment in fixed assets.

capital structure decisions the

decision-making process with funding

choices and the mix of long-term

sources of funds.

working capital management the

management of the firm’s current

assets and short-term financing.

manage a firm’s production and control its inventory and supply chain These are all

topics that involve risky choices that relate to the management of money over time,

which is the central focus of finance Although finance is primarily about the management

of money, a key component of finance is the management and interpretation of information

Indeed, if you pursue a career in management information systems or accounting,

the finance managers are likely to be your most important clients For the student

with entrepreneurial aspirations, an understanding of finance is essential—after all,

if you can’t manage your finances, you won’t be in business very long

Finally, an understanding of finance is important to you as an individual The fact

that you are reading this book indicates that you understand the importance of

investing in yourself By obtaining a higher education degree, you are clearly making

sacrifices in the hopes of making yourself more employable and improving your

chances of having a rewarding and challenging career Some of you are relying on

your own earnings and the earnings of your parents to finance your education,

whereas others are raising money or borrowing it from the financial markets, or

institutions and procedures that facilitate financial transactions.

Although the primary focus of this book is on developing corporate finance tools

that are used in business, much of the logic and many of the tools we develop will also

apply to the decisions you will have to make regarding your own personal finances

Financial decisions are everywhere, for both you and the firm you work for In the

future, both your business and personal lives will be spent in the world of finance

Since you’re going to be living in that world, it’s time to learn the basics about it

The Role of the Financial Manager

A firm can assume many different organizational structures Figure 1-2 shows a

typi-cal presentation of how the finance area fits into a firm The vice president for finance,

Oversee financial planning Strategic planning Control cash flow

Duties:

Cash management Credit management Capital expenditures Raising capital Financial planning Management of foreign currencies

Duties:

Taxes Financial statements Cost accounting Data processing

Vice President—Marketing

Vice President—Production and Operations

FIGURE 1-2 How the Finance Area Fits into a Firm

financial markets those institutions and procedures that facilitate transactions in all types of financial claims.

also called the chief financial officer (CFO), serves under the firm’s chief executive officer (CEO) and is responsible for overseeing financial planning, strategic plan-ning, and controlling the firm’s cash flow Typically, a treasurer and controller serve under the CFO In a smaller firm, the same person may fill both roles, with just one office handling all the duties The treasurer generally handles the firm’s financial activities, including cash and credit management, making capital expenditure deci-sions, raising funds, financial planning, and managing any foreign currency received

by the firm The controller is responsible for managing the firm’s accounting duties, including producing financial statements, cost accounting, paying taxes, and gather-ing and monitoring the data necessary to oversee the firm’s financial well-being In this textbook, we focus on the duties generally associated with the treasurer and on how investment decisions are made

Concept Check

1 What are the basic types of issues addressed by the study of finance?

2 What are the duties of a treasurer? Of a controller?

The Legal Forms of Business Organization

In the chapters ahead, we focus on financial decisions of corporations because, although the corporation is not the only legal form of business available, it is the most logical choice for a firm that is large or growing It is also the dominant business form in terms of sales in this country In this section we explain why this is so

Although numerous and diverse, the legal forms of business organization fall into three categories: the sole proprietorship, the partnership, and the corporation

To understand the basic differences among these forms, we need to define each one and understand its advantages and disadvantages As the firm grows, the advan-tages of the corporation begin to dominate As a result, most large firms take on the corporate form

Sole Proprietorships

A sole proprietorship is a business owned by an individual The owner retains the

title to the business’s assets and is responsible, generally without limitation, for the liabilities incurred The proprietor is entitled to the profits from the business but must also absorb any losses This form of business is initiated by the mere act of beginning the business operations Typically, no legal requirement must be met in starting the operation, particularly if the proprietor is conducting the business in his or her own name If a special name is used, an assumed-name certificate should

be filed, requiring a small registration fee Termination of the sole proprietorship occurs on the owner’s death or by the owner’s choice Briefly stated, the sole pro-

prietorship is for all practical purposes the absence of any formal legal business

structure

Partnerships

The primary difference between a partnership and a sole proprietorship is that the

partnership has more than one owner A partnership is an association of two or

more persons coming together as co-owners for the purpose of operating a business for profit Partnerships fall into two types: (1) general partnerships and (2) limited

partnerships

for the liabilities incurred by the partnership Thus, any partner’s faulty conduct,

even having the appearance of relating to the firm’s business, renders the

different legal forms of business organization.

sole proprietorship a business owned

by a single individual.

partnership an association of two or

more individuals joining together as

co-owners to operate a business for

profit.

general partnership a partnership

in which all partners are fully liable

for the indebtedness incurred by the

partnership.