CONTENTS Part 1 INTRODUCTION ... 2 1 The Goals and Functions of Financial Management ... 5 The Field of Finance ... 6 Evolution of the Field of Finance ... 7 Recent Issues in Finance ... 7 Functions of Financial Management ... 8 Forms of Organization ... 8 Sole Proprietorship ... 8 Partnership ... 9 Corporation ... 9 Goals of Financial Management ... 10 A Valuation Approach ... 11 Maximizing Shareholder Wealth ... 12 Social Responsibility and Ethical Behavior ... 13 The Role of the Financial Markets ... 14 Structure and Functions of the Financial Markets ... 15 Allocation of Capital ... 15 Institutional Pressure on Public Companies to Restructure ... 16 Internationalization of the Financial Markets ... 17 Format of the Text ... 17 Parts ... 18 1. Introduction ... 18 2. Financial Analysis and Planning ... 18 3. Working Capital Management ... 18 4. The Capital Budgeting Process ... 18 5. Long-Term Financing ... 19 6. Expanding the Perspective of Corporate Finance ... 19 List of Terms ... 19 Discussion Questions ... 19 Selected References ... 20 Part 2 FINANCIAL ANALYSIS AND PLANNING ... 22 2 Review of Accounting ... 25 Income Statement ... 26 Return to Capital ... 27 Price-Earnings Ratio Applied to Earnings per Share ... 27 Limitations of the Income Statement ... 28 Balance Sheet ... 29 Interpretation of Balance Sheet Items ... 29 Concept of Net Worth ... 31 Limitations of the Balance Sheet ... 32 Statement of Cash Flows ... 32 Developing an Actual Statement ... 33 Determining Cash Flows from Operating Activities ... 34 Determining Cash Flows from Investing Activities ... 37 Determining Cash Flows from Financing Activities ... 37 Combining the Three Sections of the Statement ... 38 Depreciation and Funds Flow ... 39 Free Cash Flow ... 41 Income Tax Considerations ... 41 Corporate Tax Rates ... 41 Cost of a Tax-Deductible Expense ... 42 Depreciation as a Tax Shield ... 42 Summary ... 43 List of Terms ... 44 Discussion Questions ... 44 Problems ... 44 Selected References ... 51 3 Financial Analysis ... 52 Ratio Analysis ... 53 Classification System ... 54 The Analysis ... 55 A. Profitability Ratios ... 56 B. Asset Utilization Ratios ... 58 C. Liquidity Ratios ... 60 D. Debt Utilization Ratios ... 61 Trend Analysis ... 62 Impact of Inflation on Financial Analysis ... 64 An Illustration ... 65 Disinflation Effect ... 66 Deflation ... 67 Other Elements of Distortion in Reported Income ... 67 Explanation of Discrepancies ... 67 Sales ... 67 Cost of Goods Sold ... 68 Extraordinary Gains/Losses ... 68 Net Income ... 69 Summary ... 69 List of Terms ... 70 Discussion Questions ... 70 Problems ... 70 Comprehensive Problems ... 80 Selected References ... 86 4 Financial Forecasting ... 87 Constructing Pro Forma Statements ... 88 Pro Forma Income Statement ... 88 Establish a Sales Projection ... 88 Determine a Production Schedule and the Gross Profit ... 89 Cost of Goods Sold ... 91 Other Expense Items ... 92 Actual Pro Forma Income Statement ... 93 Cash Budget ... 93 Cash Receipts ... 93 Cash Payments ... 94 Actual Budget ... 96 Pro Forma Balance Sheet ... 97 Explanation of Pro Forma Balance Sheet ... 99 Analysis of Pro Forma Statement ... 99 Percent-of-Sales Method ... 100 Summary ... 102 List of Terms ... 102 Discussion Questions ... 102 Problems ... 103 Comprehensive Problems ... 110 Selected References ... 113 5 Operating and Financial Leverage ... 114 Leverage in a Business ... 115 Operating Leverage ... 115 Break-Even Analysis ... 115 A More Conservative Approach ... 117 The Risk Factor ... 119 Cash Break-Even Analysis ... 119 Degree of Operating Leverage ... 120 Leveraged Firm ... 121 Conservative Firm ... 121 Limitations of Analysis ... 122 Financial Leverage ... 122 Impact on Earnings ... 123 Degree of Financial Leverage ... 125 Plan A(Leveraged) ... 126 Plan B(Conservative) ... 126 Limitations to Use of Financial Leverage ... 126 Combining Operating and Financial Leverage ... 127 Degree of Combined Leverage ... 128 A Word of Caution ... 130 Summary ... 131 Review of Formulas ... 131 List of Terms ... 132 Discussion Questions ... 132 Problems ... 133 Comprehensive Problem ... 138 Selected References ... 140 Part 3 WORKING CAPITAL MANAGEMENT ... 142 6 Working Capital and the Financing Decision ... 145 The Nature of Asset Growth ... 146 Controlling Assets - Matching Sales and Production ... 147 Temporary Assets under Level Production - an Example ... 150 Patterns of Financing ... 154 Alternative Plans ... 156 Long-Term Financing ... 157 Short-Term Financing(Opposite Approach) ... 157 The Financing Decision ... 158 Term Structure of Interest Rates ... 158 A Decision Process ... 162 Introducing Varying Conditions ... 164 Expected Value ... 164 Shifts in Asset Structure ... 165 Toward an Optimal Policy ... 165 Summary ... 167 List of Terms ... 168 Discussion Questions ... 168 Problems ... 168 Selected References ... 173 7 Current Asset Management ... 174 Cash Management ... 175 Reasons for Holding Cash Balances ... 175 Cash Flow Cycle ... 175 Collections and Disbursements ... 177 Float ... 177 Improving Collections ... 179 Extending Disbursements ... 179 Cost-Benefit Analysis ... 179 Electronic Funds Transfer ... 180 International Cash Management ... 181 Marketable Securities ... 183 Management of Accounts Receivable ... 187 Accounts Receivable as an Investment ... 187 Credit Policy Administration ... 188 Credit Standards ... 188 Terms of Trade ... 191 Collection Policy ... 191 An Actual Credit Decision ... 193 Inventory Management ... 194 Level versus Seasonal Production ... 194 Inventory Policy in Inflation(and Deflation) ... 195 The Inventory Decision Model ... 195 Carrying Costs ... 195 Ordering Costs ... 196 Economic Ordering Quantity ... 196 Safety Stock and Stock Outs ... 198 Just-in-Time Inventory Management ... 199 Cost Savings from Lower Inventory ... 199 Other Benefits ... 199 Summary ... 200 List of Terms ... 201 Discussion Questions ... 201 Problems ... 202 Comprehensive Problem ... 206 Selected References ... 207 8 Sources of Short-Term Financing ... 208 Trade Credit ... 209 Payment Period ... 209 Cash Discount Policy ... 209 Net Credit Position ... 210 Bank Credit ... 210 Prime Rate and LIBOR ... 211 Compensating Balances ... 213 Maturity Provisions ... 214 Cost of Commercial Bank Financing ... 214 Interest Costs with Compensating Balances ... 215 Rate on Installment Loans ... 216 Annual Percentage Rate ... 216 The Credit Crunch Phenomenon ... 217 Financing through Commercial Paper ... 217 Advantages of Commercial Paper ... 219 Limitations on the Issuance of Commercial Paper ... 220 Foreign Borrowing ... 220 Use of Collateral in Short-Term Financing ... 220 Accounts Receivable Financing ... 221 Pledging Accounts Receivable ... 221 Factoring Receivables ... 222 Asset-Backed Public Offerings ... 222 Inventory Financing ... 223 Stages of Production ... 224 Nature of Lender Control ... 224 Blanket Inventory Liens ... 224 Trust Receipts ... 225 Warehousing ... 225 Appraisal of Inventory Control Devices ... 225 Hedging to Reduce Borrowing Risk ... 225 Summary ... 228 List of Terms ... 228 Discussion Questions ... 229 Problems ... 229 Selected References ... 233 Part 4 THE CAPITAL BUDGETING PROCESS ... 234 9 The Time Value of Money ... 237 Relationship to the Capital Outlay Decision ... 238 Future Value - Single Amount ... 238 Present Value - Single Amount ... 239 Future Value - Annuity ... 240 Present Value - Annuity ... 243 Graphical Presentation of Time Value Relationships ... 244 The Relationship between Present Value and Future Value ... 244 The Relationship between the Present Value of a Single Amount and the Present Value of an Annuity ... 247 Future Value Related to the Future Value of an Annuity ... 248 Determining the Annuity Value ... 250 Annuity Equaling a Future Value ... 250 Annuity Equaling a Present Value ... 250 Determining the Yield on an Investment ... 252 Yield - Present Value of a Single Amount ... 252 Yield - Present Value of an Annuity ... 253 Special Considerations in Time Value Analysis ... 254 Patterns of Payment ... 254 Special Review of the Chapter ... 257 List of Terms ... 259 Discussion Questions ... 259 Problems ... 260 Selected References ... 264 10 Valuation and Rates of Return ... 265 Valuation Concepts ... 266 Valuation of Bonds ... 266 Present Value of Interest Payments ... 267 Present Value of Principal Payment(Par Value) at Maturity ... 268 Concept of Yield to Maturity ... 268 Changing the Yield to Maturity and the Impact on Bond Valuation ... 270 Increase in Inflation Premium ... 270 Decrease in Inflation Premium ... 271 Time to Maturity ... 272 Determining Yield to Maturity from the Bond Price ... 273 A 13 Percent Discount Rate ... 274 A 12 Percent Discount Rate ... 274 Formula for Bond Yield ... 275 Semiannual Interest and Bond Prices ... 276 Valuation and Preferred Stock ... 277 Determining the Required Rate of Return(Yield) from the Market Price ... 279 Valuation of Common Stock ... 279 No Growth in Dividends ... 280 Constant Growth in Dividends ... 280 Stock Valuation Based on Future Stock Value ... 282 Determining the Required Rate of Return from the Market Price ... 283 The Price-Earnings Ratio Concept and Valuation ... 284 Variable Growth in Dividends ... 287 Summary and Review of Formulas ... 288 Bonds ... 288 Preferred Stock ... 289 Common Stock ... 289 List of Terms ... 290 Discussion Questions ... 290 Problems ... 291 Selected References ... 295 Appendix 10A The Bond Yield to Maturity Using Interpolation ... 295 Appendix 10B Valuation of a Supernormal Growth Firm ... 297 Problem ... 299 11 Cost of Capital ... 300 The Overall Concept ... 301 Cost of Debt ... 302 Cost of Preferred Stock ... 304 Cost of Common Equity ... 305 Valuation Approach ... 305 Alternate Calculation of the Required Return on Common Stock ... 306 Cost of Retained Earnings ... 307 Cost of New Common Stock ... 308 Overview of Common Stock Costs ... 309 Optimal Capital Structure - Weighting Costs ... 309 Capital Acquisition and Investment Decision Making ... 312 Cost of Capital in the Capital Budgeting Decision ... 312 The Marginal Cost of Capital ... 314 Summary ... 319 Review of Formulas ... 320 List of Terms ... 321 Discussion Questions ... 321 Problems ... 322 Comprehensive Problems ... 327 Selected References ... 329 Appendix 11A Cost of Capital and the Capital Asset Pricing Model(Optional) ... 330 The Capital Asset Pricing Model ... 330 The Security Market Line ... 332 Cost of Capital Consideration ... 334 List of Terms ... 336 Discussion Questions ... 336 Problems ... 337 Appendix 11B Capital Structure Theory and Modigliani and Miller ... 337 Net Income(NI) Approach ... 337 Net Operating Income(NOI) Approach ... 337 Modigliani and Miller's Initial Approach ... 339 Modigliani and Miller with the Introduction of Corporate Taxes ... 340 Modigliani and Miller with Bankruptcy Considerations ... 341 The Miller Model ... 343 List of Terms ... 343 Discussion Questions ... 343 12 The Capital Budgeting Decision ... 344 Administrative Considerations ... 345 Accounting Flows versus Cash Flows ... 346 Methods of Ranking Investment Proposals ... 348 Payback Method ... 349 Internal Rate of Return ... 350 Net Present Value ... 352 Selection Strategy ... 353 Reinvestment Assumption ... 354 Capital Rationing ... 355 Net Present Value Profile ... 356 Characteristics of Investment C ... 358 Combining Cash Flow Analysis and Selection Strategy ... 360 The Rules of Depreciation ... 360 The Tax Rate ... 362 Actual Investment Decision ... 362 The Replacement Decision ... 363 Sale of Old Asset ... 364 Incremental Depreciation ... 366 Cost Savings ... 367 Elective Expensing ... 368 Summary ... 369 List of Terms ... 369 Discussion Questions ... 369 Problems ... 370 Comprehensive Problems ... 377 Selected References ... 378 13 Risk and Capital Budgeting ... 379 Definition of Risk in Capital Budgeting ... 380 The Concept of Risk-Averse ... 380 Actual Measurement of Risk ... 382 Risk and the Capital Budgeting Process ... 384 Risk-Adjusted Discount Rate ... 385 Increasing Risk over Time ... 385 Qualitative Measures ... 387 Example - Risk-Adjusted Discount Rate ... 387 Simulation Models ... 389 Decision Trees ... 390 The Portfolio Effect ... 391 Portfolio Risk ... 393 Evaluation of Combinations ... 395 The Share Price Effect ... 396 Summary ... 396 Review of Formulas ... 396 List of Terms ... 397 Discussion Questions ... 397 Problems ... 398 Comprehensive Problems ... 405 Selected References ... 407 Part 5 LONG-TERM FINANCING ... 408 14 Capital Markets ... 411 International Capital Markets ... 412 Competition for Funds in the U.S. Capital Markets ... 414 Government Securities ... 414 U.S. Government Securities ... 414 Federally Sponsored Credit Agencies ... 415 State and Local Issues ... 416 Corporate Securities ... 416 Corporate Bonds ... 416 Preferred Stock ... 417 Common Stock ... 418 Internal versus External Sources of Funds ... 418 The Supply of Capital Funds ... 419 The Role of the Security Markets ... 420 The Organization of the Security Markets ... 421 The Organized Exchanges ... 421 The New York Stock Exchange ... 423 Size and Liquidity ... 423 Listing Requirements ... 423 Foreign Exchanges ... 423 The Over-the-Counter Markets ... 424 Market Efficiency ... 425 Criteria of Efficiency ... 425 Screen-Based Trading versus Floor Trading ... 426 The Efficient Market Hypothesis ... 426 Regulation of the Security Markets ... 428 Securities Act of 1933 ... 428 Securities Exchange Act of 1934 ... 429 Securities Acts Amendments of 1975 ... 430 Current Legislative Issues ... 430 Summary ... 431 List of Terms ... 432 Discussion Questions ... 432 Selected References ... 433 15 Investment Banking : Public and Private Placement ... 434 The Role of Investment Banking ... 435 Enumeration of Functions ... 435 Underwriter ... 436 Market Maker ... 437 Advisor ... 437 Agency Functions ... 437 The Distribution Process ... 437 The Spread ... 438 Pricing the Security ... 439 Dilution ... 440 Market Stabilization ... 440 Aftermarket ... 441 Changes in the Investment Banking Industry ... 441 Shelf Registration ... 443 Public versus Private Financing ... 443 Advantages of Being Public ... 443 Disadvantages of Being Public ... 444 Public Offerings ... 444 A Classic Example of Instant Wealth - EDS Goes Public ... 444 Netscape ... 445 Private Placement ... 447 Going Private and Leveraged Buyouts ... 447 International Investment Banking Deals ... 449 Privatization ... 449 Summary ... 449 List of Terms ... 452 Discussion Questions ... 452 Problems ... 453 Selected References ... 459 16 Long-Term Debt and Lease Financing ... 466 The Expanding Role of Debt ... 461 The Debt Contract ... 462 Par Value ... 462 Coupon Rate ... 462 Maturity Date ... 462 Security Provisions ... 462 Unsecured Debt ... 463 Methods of Repayment ... 463 Serial Payments ... 464 Sinking-Fund Provision ... 464 Conversion ... 464 Call Feature ... 464 An Example : Penney's 8⅛ Percent Bond ... 464 Bond Prices, Yields, and Ratings ... 466 Bond Yields ... 468 Coupon Rate(Nominal Yield) ... 468 Current Yield ... 468 Yield to Maturity ... 468 Bond Ratings ... 469 Examining Actual Bond Ratings ... 469 The Refunding Decision ... 470 A Capital Budgeting Problem ... 470 Step A - Outflow Considerations ... 471 Step B - Inflow Considerations ... 472 Step C - Net Present Value ... 473 Other Forms of Bond Financing ... 474 Advantages and Disadvantages of Debt ... 475 Benefits of Debt ... 476 Drawbacks of Debt ... 476 Eurobond Market ... 476 Leasing as a Form of Debt ... 478 Capital Lease versus Operating Lease ... 479 Income Statement Effect ... 480 Advantages of Leasing ... 480 Summary ... 481 List of Terms ... 482 Discussion Questions ... 482 Problems ... 483 Selected References ... 487 Appendix 16A Financial Alternatives for Distressed Firms ... 487 Out-of-Court Settlement ... 488 In-Court Settlements - Formal Bankruptcy ... 489 Reorganization ... 489 Liquidation ... 489 List of Terms ... 493 Discussion Questions ... 493 Problem ... 493 Appendix 16B Lease versus Purchase Decision ... 494 Problem ... 497 17 Common and Preferred Stock Financing ... 498 Common Stockholders' Claim to Income ... 500 The Voting Right ... 500 Cumulative Voting ... 501 The Right to Purchase New Shares ... 503 The Use of Rights in Financing ... 504 Rights Required ... 504 Monetary Value of a Right ... 504 Effect of Rights on Stockholder's Position ... 506 Desirable Features of Rights Offerings ... 507 Poison Pills ... 508 American Depository Receipts ... 508 Preferred Stock Financing ... 510 Justification for Preferred Stock ... 510 Investor Interest ... 510 Summary of Tax Considerations ... 512 Provisions Associated with Preferred Stock ... 512 1. Cumulative Dividends ... 512 2. Conversion Feature ... 512 3. Call Feature ... 513 4. Participation Provision ... 513 5. Floating Rate ... 513 6. Dutch Auction Preferred Stock ... 513 7. Par Value ... 514 Comparing Features of Common and Preferred Stock and Debt ... 514 Summary ... 515 Review of Formulas ... 516 List of Terms ... 517 Discussion Questions ... 517 Problems ... 518 Comprehensive Problems ... 522 Selected References ... 524 18 Dividend Policy and Retained Earnings ... 525 The Marginal Principle of Retained Earnings ... 526 Life Cycle Growth and Dividends ... 526 Dividends as a Passive Variable ... 527 An Incomplete Theory ... 527 Arguments for the Relevance of Dividends ... 528 Dividend Stability ... 529 Other Factors Influencing Dividend Policy ... 530 Legal Rules ... 530 Cash Position of the Firm ... 532 Access to Capital Markets ... 532 Desire for Control ... 532 Tax Position of Shareholders ... 532 Dividend Payment Procedures ... 533 Stock Dividend ... 534 Accounting Considerations for a Stock Dividend ... 534 Value to the Investor ... 535 Possible Value of Stock Dividends ... 536 Use of Stock Dividends ... 536 Stock Splits ... 536 Repurchase of Stock as an Alternative to Dividends ... 537 Other Reasons for Repurchase ... 539 Dividend Reinvestment Plans ... 541 Summary ... 541 List of Terms ... 542 Discussion Questions ... 542 Problems ... 543 Selected References ... 549 19 Convertibles and Warrants ... 550 Convertible Securities ... 551 Value of the Convertible Bond ... 551 Is This Fool's Gold? ... 554 Advantages and Disadvantages to the Corporation ... 554 Forcing Conversion ... 556 Euro-Convertible Bonds ... 557 Accounting Considerations with Convertibles ... 558 Financing through Warrants ... 560 Valuation of Warrants ... 561 Use of Warrants in Corporate Finance ... 563 Accounting Considerations with Warrants ... 564 Summary ... 564 Review of Formulas ... 565 List of Terms ... 565 Discussion Questions ... 565 Problems ... 566 Comprehensive Problems ... 570 Selected References ... 571 Part 6 EXPANDING THE PERSPECTIVE OF CORPORATE FINANCE ... 572 20 External Growth through Mergers ... 575 Motives for Business Combinations ... 576 Financial Motives ... 577 Nonfinancial Motives ... 580 Motives of Selling Stockholders ... 580 Terms of Exchange ... 580 Cash Purchases ... 581 Stock-for-Stock Exchange ... 582 Portfolio Effect ... 583 Accounting Considerations in Mergers and Acquisitions ... 584 Negotiated versus Tendered Offers ... 585 Premium Offers and Stock Price Movements ... 586 Two-Step Buyout ... 587 Summary ... 588 List of Terms ... 589 Discussion Questions ... 589 Problems ... 590 Selected References ... 593 21 International Financial Management ... 594 The Multinational Corporation : Nature and Environment ... 596 Exporter ... 596 Li