Analyzing Financial Performance

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The Logic and Practice of Financial Management

Ninth Edition

Foundations of Finance

The Pearson Series in Finance

Berk/DeMarzo Corporate Finance* Corporate Finance: The Core*

Berk/DeMarzo/Harford Fundamentals of Corporate Finance*

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Dorfman/Cather Introduction to Risk Management and Insurance

Eakins/McNally Corporate Finance Online*

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Marthinsen Risk Takers: Uses and Abuses of Financial Derivatives

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Smart/Gitman/Joehnk Fundamentals of Investing*

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The Logic and Practice of Financial Management

Ninth Edition

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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

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Library of Congress Cataloging-in-Publication Data

Names: Keown, Arthur J. | Martin, John D. | Petty, J. William Title: Foundations of finance: the logic and practice of financial

management/Arthur J. Keown, John D. Martin, J. William Petty. Description: Ninth Edition. | Boston : Pearson, 2016. | Series: The pearson series in finance | Revised edition of Foundations of finance, 2014.

| Includes bibliographical references and index. Identifiers: LCCN 2015039822| ISBN 9780134083285 (alk. paper) | ISBN 0134083288 (alk. paper) Subjects: LCSH: Corporations–Finance. Classification: LCC HG4026.F67 2016 | DDC 658.15–dc23 LC record available at http://lccn.loc.gov/2015039822

ISBN 10: 0-13-408328-8 ISBN 13: 978-0-13-408328-5

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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

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

vii

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.

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Preface xvii

PART 1 The Scope and Environment of Financial Management 2

1 An Introduction to the Foundations of Financial Management 2 2 The Financial Markets and Interest Rates 22 3 Understanding Financial Statements and Cash Flows 54 4 Evaluating a Firm’s Financial Performance 106

PART 2 The Valuation of Financial Assets 152 5 The Time Value of Money 152 6 The Meaning and Measurement of Risk and Return 196 7 The Valuation and Characteristics of Bonds 236 8 The Valuation and Characteristics of Stock 268 9 The Cost of Capital 294

PART 3 Investment in Long-Term Assets 326 10 Capital-Budgeting Techniques and Practice 326 11 Cash Flows and Other Topics in Capital Budgeting 368

PART 4 Capital Structure and Dividend Policy 406 12 Determining the Financing Mix 406 13 Dividend Policy and Internal Financing 444

PART 5 Working-Capital Management and International Business Finance 466

14 Short-Term Financial Planning 466 15 Working-Capital Management 486 16 International Business Finance 514

Web 17 Cash, Receivables, and Inventory Management Available online at www.myfinancelab.com Web Appendix A Using a Calculator Available online at www.myfinancelab.com

Glossary 536 Indexes 545

Brief Contents

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Contents Preface xvii

PART 1 The Scope and Environment of Financial Management 2

1 An Introduction to the Foundations of Financial Management 2 The Goal of the Firm 3

Five Principles That Form the Foundations of Finance 4 Principle 1: Cash Flow Is What Matters 4 Principle 2: Money Has a Time Value 5 Principle 3: Risk Requires a Reward 5 Principle 4: Market Prices Are Generally Right 6 Principle 5: Conflicts of Interest Cause Agency Problems 8 The Global Financial Crisis 9 Avoiding Financial Crisis—Back to the Principles 10 The Essential Elements of Ethics and Trust 11

The Role of Finance in Business 12 Why Study Finance? 12 The Role of the Financial Manager 13

The Legal Forms of Business Organization 14 Sole Proprietorships 14 Partnerships 14 Corporations 15 Organizational Form and Taxes: The Double Taxation on Dividends 15 S-Corporations and Limited Liability Companies (LLCs) 16 Which Organizational Form Should Be Chosen? 16

Finance and the Multinational Firm: The New Role 17

Chapter Summaries 18 • Review Questions 20 • Mini Case 21

2 The Financial Markets and Interest Rates 22 Financing of Business: The Movement of Funds Through

the Economy 24 Public Offerings Versus Private Placements 25 Primary Markets Versus Secondary Markets 26 The Money Market Versus the Capital Market 27 Spot Markets Versus Futures Markets 27 Stock Exchanges: Organized Security Exchanges Versus Over-the-Counter

Markets, a Blurring Difference 27

Selling Securities to the Public 29 Functions 29 Distribution Methods 30 Private Debt Placements 31 Flotation Costs 33 Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley

Act 33

Rates of Return in the Financial Markets 34 Rates of Return over Long Periods 34 Interest Rate Levels in Recent Periods 35

Interest Rate Determinants in a Nutshell 38 Estimating Specific Interest Rates Using Risk Premiums 38 Real Risk-Free Interest Rate and the Risk-Free Interest Rate 39 Real and Nominal Rates of Interest 39 Inflation and Real Rates of Return: The Financial Analyst’s Approach 41 The Term Structure of Interest Rates 43 Shifts in the Term Structures of Interest Rates 43 What Explains the Shape of the Term Structure? 45

Chapter Summaries 47 • Review Questions 50 • Study Problems 50 • Mini Case 53

3 Understanding Financial Statements and Cash Flows 54 The Income Statement 56

Coca-Cola’s Income Statement 58 Restating Coca-Cola’s Income Statement 59

The Balance Sheet 61 Types of Assets 61 Types of Financing 63 Coca-Cola’s Balance Sheet 65 Working Capital 66

Measuring Cash Flows 69 Profits Versus Cash Flows 69 The Beginning Point: Knowing When a Change in the Balance Sheet Is a Source

or Use of Cash 71 Statement of Cash Flows 71 Concluding Suggestions for Computing Cash Flows 78 What Have We Learned about Coca-Cola? 79

GAAP and IFRS 79

Income Taxes and Finance 80 Computing Taxable Income 80 Computing the Taxes Owed 81

The Limitations of Financial Statements and Accounting Malpractice 83

Chapter Summaries 85 • Review Questions 88 • Study Problems 89 • Mini Case 97

Appendix 3A: Free Cash Flows 100 Computing Free Cash Flows 100

Computing Financing Cash Flows 105

Study Problems 104

4 Evaluating a Firm’s Financial Performance 106 The Purpose of Financial Analysis 106

Measuring Key Financial Relationships 110 Question 1: How Liquid Is the Firm—Can It Pay Its Bills? 111 Question 2: Are the Firm’s Managers Generating Adequate Operating Profits

on the Company’s Assets? 116 Managing Operations 118 Managing Assets 119 Question 3: How Is the Firm Financing Its Assets? 123 Question 4: Are the Firm’s Managers Providing a Good Return on the Capital

Provided by the Company’s Shareholders? 126 Question 5: Are the Firm’s Managers Creating Shareholder Value? 131

x Contents

Contents xi

The Limitations of Financial Ratio Analysis 138

Chapter Summaries 139 • Review Questions 142 • Study Problems 142 • Mini Case 150

PART 2 The Valuation of Financial Assets 152

5 The Time Value of Money 152 Compound Interest, Future Value, and Present Value 154

Using Timelines to Visualize Cash Flows 154 Techniques for Moving Money Through Time 157 Two Additional Types of Time Value of Money Problems 162 Applying Compounding to Things Other Than Money 163 Present Value 164

Annuities 168 Compound Annuities 168 The Present Value of an Annuity 170 Annuities Due 172 Amortized Loans 173

Making Interest Rates Comparable 175 Calculating the Interest Rate and Converting It to an EAR 177 Finding Present and Future Values With Nonannual Periods 178 Amortized Loans With Monthly Compounding 181

The Present Value of an Uneven Stream and Perpetuities 182 Perpetuities 183

Chapter Summaries 184 • Review Questions 187 • Study Problems 187 • Mini Case 195

6 The Meaning and Measurement of Risk and Return 196 Expected Return Defined and Measured 198

Risk Defined and Measured 201

Rates of Return: The Investor’s Experience 208

Risk and Diversification 209 Diversifying Away the Risk 210 Measuring Market Risk 211 Measuring a Portfolio’s Beta 218 Risk and Diversification Demonstrated 219

The Investor’s Required Rate of Return 222 The Required Rate of Return Concept 222 Measuring the Required Rate of Return 222

Chapter Summaries 225 • Review Questions 229 • Study Problems 229 • Mini Case 234

7 The Valuation and Characteristics of Bonds 236 Types of Bonds 237

Debentures 237 Subordinated Debentures 238 Mortgage Bonds 238 Eurobonds 238 Convertible Bonds 238

xii Contents

Terminology and Characteristics of Bonds 239 Claims on Assets and Income 239 Par Value 239 Coupon Interest Rate 240 Maturity 240 Call Provision 240 Indenture 240 Bond Ratings 241

Defining Value 242

What Determines Value? 244

Valuation: The Basic Process 245

Valuing Bonds 246

Bond Yields 252 Yield to Maturity 252 Current Yield 254

Bond Valuation: Three Important Relationships 255

Chapter Summaries 260 • Review Questions 263 • Study Problems 264 • Mini Case 267

8 The Valuation and Characteristics of Stock 268 Preferred Stock 269

The Characteristics of Preferred Stock 270

Valuing Preferred Stock 271

Common Stock 275 The Characteristics of Common Stock 275

Valuing Common Stock 277

The Expected Rate of Return of Stockholders 282 The Expected Rate of Return of Preferred Stockholders 283 The Expected Rate of Return of Common Stockholders 284

Chapter Summaries 287 • Review Questions 290 • Study Problems 290 • Mini Case 293

9 The Cost of Capital 294 The Cost of Capital: Key Definitions and Concepts 295

Opportunity Costs, Required Rates of Return, and the Cost of Capital 295

The Firm’s Financial Policy and the Cost of Capital 296

Determining the Costs of the Individual Sources of Capital 297 The Cost of Debt 297 The Cost of Preferred Stock 299 The Cost of Common Equity 301 The Dividend Growth Model 302 Issues in Implementing the Dividend Growth Model 303 The Capital Asset Pricing Model 304 Issues in Implementing the CAPM 305

The Weighted Average Cost of Capital 307 Capital Structure Weights 308 Calculating the Weighted Average Cost of Capital 308

Contents xiii

Calculating Divisional Costs of Capital 311 Estimating Divisional Costs of Capital 311 Using Pure Play Firms to Estimate Divisional WACCs 311 Using a Firm’s Cost of Capital to Evaluate New Capital Investments 313

Chapter Summaries 317 • Review Questions 319 • Study Problems 320 • Mini Cases 324

PART 3 Investment in Long-Term Assets 326

10 Capital-Budgeting Techniques and Practice 326 Finding Profitable Projects 327

Capital-Budgeting Decision Criteria 328 The Payback Period 328 The Net Present Value 332 Using Spreadsheets to Calculate the Net Present Value 335 The Profitability Index (Benefit–Cost Ratio) 335 The Internal Rate of Return 338 Computing the IRR for Uneven Cash Flows with a Financial Calculator 340 Viewing the NPV–IRR Relationship: The Net Present Value Profile 341 Complications with the IRR: Multiple Rates of Return 343 The Modified Internal Rate of Return (MIRR) 344 Using Spreadsheets to Calculate the MIRR 347 A Last Word on the MIRR 347

Capital Rationing 348 The Rationale for Capital Rationing 349 Capital Rationing and Project Selection 349

Ranking Mutually Exclusive Projects 350 The Size-Disparity Problem 350 The Time-Disparity Problem 351 The Unequal-Lives Problem 352

Chapter Summaries 356 • Review Questions 359 • Study Problems 359 • Mini Case 366

11 Cash Flows and Other Topics in Capital Budgeting 368 Guidelines for Capital Budgeting 369

Use Free Cash Flows Rather Than Accounting Profits 369 Think Incrementally 369 Beware of Cash Flows Diverted from Existing Products 370 Look for Incidental or Synergistic Effects 370 Work in Working-Capital Requirements 370 Consider Incremental Expenses 371 Remember That Sunk Costs Are Not Incremental Cash Flows 371 Account for Opportunity Costs 371 Decide If Overhead Costs Are Truly Incremental Cash Flows 371 Ignore Interest Payments and Financing Flows 372

Calculating a Project’s Free Cash Flows 372 What Goes into the Initial Outlay 372 What Goes into the Annual Free Cash Flows over the Project’s Life 373 What Goes into the Terminal Cash Flow 375 Calculating the Free Cash Flows 375 A Comprehensive Example: Calculating Free Cash Flows 379

Options in Capital Budgeting 382 The Option to Delay a Project 383 The Option to Expand a Project 383 The Option to Abandon a Project 384 Options in Capital Budgeting: The Bottom Line 384

xiv Contents

Risk and the Investment Decision 385 What Measure of Risk Is Relevant in Capital Budgeting? 386 Measuring Risk for Capital-Budgeting Purposes with a Dose of Reality—Is

Systematic Risk All There Is? 387 Incorporating Risk into Capital Budgeting 387 Risk-Adjusted Discount Rates 387 Measuring a Project’s Systematic Risk 390 Using Accounting Data to Estimate a Project’s Beta 391 The Pure Play Method for Estimating Beta 391 Examining a Project’s Risk Through Simulation 391 Conducting a Sensitivity Analysis Through Simulation 393

Chapter Summaries 394 • Review Questions 396 • Study Problems 396 • Mini Case 402

Appendix 11A: The Modified Accelerated Cost Recovery System 404 What Does All This Mean? 405

Study Problems 405

PART 4 Capital Structure and Dividend Policy 406

12 Determining the Financing Mix 406 Understanding the Difference Between Business and Financial

Risk 408 Business Risk 409 Operating Risk 409

Break-Even Analysis 409 Essential Elements of the Break-Even Model 410 Finding the Break-Even Point 412 The Break-Even Point in Sales Dollars 413

Sources of Operating Leverage 414 Financial Leverage 416 Combining Operating and Financial Leverage 418

Capital Structure Theory 420 A Quick Look at Capital Structure Theory 422 The Importance of Capital Structure 422 Independence Position 422 The Moderate Position 424 Firm Value and Agency Costs 426 Agency Costs, Free Cash Flow, and Capital Structure 428 Managerial Implications 428

The Basic Tools of Capital Structure Management 429 EBIT-EPS Analysis 429 Comparative Leverage Ratios 432 Industry Norms 433 Net Debt and Balance-Sheet Leverage Ratios 433 A Glance at Actual Capital Structure Management 433

Chapter Summaries 436 • Review Questions 439 • Study Problems 439 • Mini Cases 442

13 Dividend Policy and Internal Financing 444 Key Terms 445

Does Dividend Policy Matter to Stockholders? 446 Three Basic Views 446 Making Sense of Dividend Policy Theory 449 What Are We to Conclude? 451

Contents xv

The Dividend Decision in Practice 452 Legal Restrictions 452 Liquidity Constraints 452 Earnings Predictability 453 Maintaining Ownership Control 453 Alternative Dividend Policies 453 Dividend Payment Procedures 453

Stock Dividends and Stock Splits 454

Stock Repurchases 455 A Share Repurchase as a Dividend Decision 456 The Investor’s Choice 457 A Financing or an Investment Decision? 458 Practical Considerations—The Stock Repurchase Procedure 458

Chapter Summaries 459 • Review Questions 461 • Study Problems 462 • Mini Case 465

PART 5 Working-Capital Management and International Business Finance 466

14 Short-Term Financial Planning 466 Financial Forecasting 467

The Sales Forecast 467 Forecasting Financial Variables 467 The Percent of Sales Method of Financial Forecasting 468 Analyzing the Effects of Profitability and Dividend Policy

on DFN 469 Analyzing the Effects of Sales Growth on a Firm’s DFN 470

Limitations of the Percent of Sales Forecasting Method 473

Constructing and Using a Cash Budget 474 Budget Functions 474 The Cash Budget 475

Chapter Summaries 477 • Review Questions 478 • Study Problems 479 • Mini Case 484

15 Working-Capital Management 486 Managing Current Assets and Liabilities 487

The Risk–Return Trade-Off 488 The Advantages of Current versus Long-term Liabilities: Return 488 The Disadvantages of Current versus Long-term Liabilities: Risk 488

Determining the Appropriate Level of Working Capital 489 The Hedging Principle 489 Permanent and Temporary Assets 490 Temporary, Permanent, and Spontaneous Sources of Financing 490 The Hedging Principle: A Graphic Illustration 491

The Cash Conversion Cycle 492

Estimating the Cost of Short-Term Credit Using the Approximate Cost-of-Credit Formula 494

Sources of Short-Term Credit 496 Unsecured Sources: Accrued Wages and Taxes 497 Unsecured Sources: Trade Credit 498 Unsecured Sources: Bank Credit 499 Unsecured Sources: Commercial Paper 501

xvi Contents

Secured Sources: Accounts-Receivable Loans 503 Secured Sources: Inventory Loans 505

Chapter Summaries 506 • Review Questions 509 • Study Problems 510

16 International Business Finance 514 The Globalization of Product and Financial Markets 515

Foreign Exchange Markets and Currency Exchange Rates 516 Foreign Exchange Rates 517 What a Change in the Exchange Rate Means for Business 517 Exchange Rates and Arbitrage 520 Asked and Bid Rates 520 Cross Rates 520 Types of Foreign Exchange Transactions 522 Exchange Rate Risk 524

Interest Rate Parity 526

Purchasing-Power Parity and the Law of One Price 527 The International Fisher Effect 528

Capital Budgeting for Direct Foreign Investment 528 Foreign Investment Risks 529

Chapter Summaries 530 • Review Questions 532 • Study Problems 533 • Mini Case 534

Web 17 Cash, Receivables, and Inventory Management Available online at www.myfinancelab.com

Web Appendix A Using a Calculator Available online at www.myfinancelab.com

Glossary 536

Indexes 545

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xvii

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 mate- 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.

New to the Ninth Edition Technology is ever present in our lives today, and we are beginning to see its effec- tive use in education. One form of learning technology that we believe has great 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-by- chapter updates in response to the continued development of financial thought, reviewer comments, and the recent economic crisis. Some of these changes include:

Chapter 1 An Introduction to the Foundations of Financial Management

◆ Revised and updated chapter introduction ◆ Revised and updated discussion of the five principles

Chapter 2 The Financial Markets and Interest Rates

◆ Revised coverage of the term structure of interest rates to address the very low rates that characterize today’s markets

◆ Simplified, more intuitive discussion on interest rate determinants ◆ Added coverage of the term structure of interest rates into the end-of-chapter

problems

Chapter 3 Understanding Financial Statements and Cash Flows

◆ Uses The Coca-Cola Company, a firm all students are familiar with, to help them understand financial statements

◆ Expanded coverage of balance sheets, focusing on what can be learned from them

Preface

xviii Preface

◆ More intuitive presentation of cash flows ◆ New explanation of fixed and variable costs as part of presenting an income

statement ◆ Four lecture videos accompany the in-chapter examples.

Chapter 4 Evaluating a Firm’s Financial Performance

◆ Continues the use of The Coca-Cola Company’s financial data to illustrate how 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.

◆ Provides a new Finance at Work box, based on an example from the soft-drink industry

◆ Revised presentation of evaluating a company’s liquidity to align more closely with how business managers talk about liquidity

◆ Four lecture videos accompany the in-chapter examples.

Chapter 5 The Time Value of Money

◆ Revised to appeal to all students regardless of their level of mathematical skill ◆ New section added on “Making Interest Rates Comparable,” with new end-of-

chapter questions dealing with calculation of the effective annual rate ◆ Additional problems emphasizing complex streams of cash flows ◆ Thirteen lecture videos accompany the in-chapter examples.

Chapter 6 The Meaning and Measurement of Risk and Return

◆ Updated information on the rates of return that investors have earned over the long term with different types of security investments

◆ Numerous new examples involving companies the students are familiar with are presented throughout the chapter to illustrate the concepts and applications in the chapter.

◆ Two lecture videos accompany the in-chapter examples.

Chapter 7 The Valuation and Characteristics of Bonds

◆ A number of new examples involving real-life firms ◆ Two lecture videos accompany the in-chapter examples.

Chapter 8 The Valuation and Characteristics of Stock

◆ More current explanation of options for getting stock quotes from the Wall Street Journal

◆ Four lecture videos accompany the in-chapter examples.

Chapter 9 The Cost of Capital

◆ Five lecture videos correspond to the five major in-chapter examples ◆ Eight end-of-chapter problems revised or replaced by new problem exercises

Preface xix

Chapter 10 Capital-Budgeting Techniques and Practice

◆ Extensively revised chapter introduction, which looks at Disney’s decision to build the Shanghai Disney Resort

◆ Addition of a new section along with additional discussion of the modified inter- nal rate of return that not only summarizes the tool, but also provides important caveats concerning its use

◆ Eight lecture videos accompany the in-chapter examples.

Chapter 11 Cash Flows and Other Topics in Capital Budgeting

◆ Revised introduction examining the difficulties Toyota faced in estimating future cash flows when it introduced the Prius

◆ New Finance at Work box dealing with Disney World ◆ Problem set revised to include additional coverage of real options ◆ Three lecture videos accompany the in-chapter examples.

Chapter 12 Determining the Financing Mix

◆ Problem set revised to include two new and one revised exercise ◆ Two lecture videos accompany the in-chapter examples.

Chapter 13 Dividend Policy and Internal Financing

◆ Updated discussion of the tax code for personal tax treatment of dividends and capital gains

◆ A lecture video accompanies the in-chapter example.

Chapter 14 Short-Term Financial Planning

◆ Two new problems added ◆ Two lecture videos accompany the in-chapter examples.

Chapter 15 Working-Capital Management

◆ Four new problem exercises added ◆ Five lecture videos accompany the in-chapter examples.

Chapter 16 International Business Finance

◆ Revised extensively to reflect changes in exchange rates and global financial markets ◆ A new section titled “What a Change in the Exchange Rate Means for Business”

deals with the implications of exchange rate changes ◆ Three lecture videos accompany the in-chapter examples.

Web Chapter 17 Cash, Receivables, and Inventory Management

◆ Simplified presentation of chapter materials

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-making 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:

◆ We build our discussion around the five finance principles that provide the foun- dation for the valuation of any investment.

◆ We introduce new topics in the context of “what is the value proposition?” and “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

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

LO2 Understand the basic principles of finance, their importance, and the importance of ethics and trust.

1 PRINCIPLE

M01_KEOW3285_09_SE_C01.indd 4 28/11/15 2:53 PM

xx Preface

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.

◆ First, we present math only as a tool to help us analyze problems, and only when necessary. We do not present math for its own sake.

◆ Second, finance is an analytical subject and requires that students be able to 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 infla- tion rate of 5 percent, we can calculate the real rate of interest as follows:

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

0.113 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 cor- rect, few practicing analysts or executives use it. Rather, they employ some version of

2In 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 esti-

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%

12 PART 1 • The Scope and Environment of Financial Management

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?

LO3 Describe the role of finance in business.

Preface xxi

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 presenta- tion of the time value of money and valua- tion. Where appropriate, actual calculator and spreadsheet solutions appear in the text.

Chapter Summaries That Bring Together Concepts, Terminology, and Applications The chapter summaries have been written in a way that connects them to the in- chapter sections and learning objectives. For each learning objective, the student sees in one place the concepts, new terminology, 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 prob- 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.

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.

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?

02/12/15 2:00 PM

(5-2)

CALCULATOR SOLUTION

Data Input Function Key

10 N

6 I/Y

-500 FV

0 PMT

Function Key Answer

CPT

PV 279.20

MyFinanceLab Video

02/12/15 2:11 PM

CHAPTER 2 • The Financial Markets and Interest Rates 53

Mini Case This Mini Case is available in MyFinanceLab.

On the first day of your summer internship, you’ve been assigned to work with the chief financial officer (CFO) of SanBlas Jewels Inc. Not knowing how well trained you are, the CFO has decided to test your understanding of interest rates. Specifi- cally, she asks you to provide a reasonable estimate of the nominal interest rate for a new issue of Aaa-rated bonds to be offered by SanBlas Jewels Inc. The final format that the chief financial officer of SanBlas Jewels has requested is that of equation (2-1) in the text. Your assignment also requires that you consult the data in Table 2-2.

Some agreed-upon procedures related to generating estimates for key variables in equation (2-1) follow.

a. The current 3-month Treasury bill rate is 2.96 percent, the 30-year Treasury bond rate is 5.43 percent, the 30-year Aaa-rated corporate bond rate is 6.71 percent, and the inflation rate is 2.33 percent.

b. The real risk-free rate of interest is the difference between the calculated aver- age yield on 3-month Treasury bills and the inflation rate.

c. The default-risk premium is estimated by the difference between the average yields on Aaa-rated bonds and 30-year Treasury bonds.

d. The maturity-risk premium is estimated by the difference between the average yields on 30-year Treasury bonds and 3-month Treasury bills.

e. SanBlas Jewels’ bonds will be traded on the New York Bond Exchange, so the liquidity-risk premium will be slight. It will be greater than zero, however, because the secondary market for the firm’s bonds is more uncertain than that of some other jewel sellers. It is estimated at 4 basis points. A basis point is one one-hundredth of 1 percent.

Now place your output into the format of equation (2-1) so that the nominal interest rate can be estimated and the size of each variable can also be inspected for reason- ableness and discussion with the CFO.

xxii Preface

A Complete Support Package for the Student and Instructor MyFinanceLab This fully integrated online homework system gives students the hands-on prac- 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.

Instructor’s Resource Center This password-protected site, accessible at http://www.pearsonhighered.com/irc, 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, pro- 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; and organize a database of tests 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 fol- lows the textbook’s organization and represents a continued effort to serve the teach- er’s goal of being effective in the classroom. Each chapter contains a chapter orienta- tion, 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.pearsonhighered. com/irc.

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.

Preface xxiii

http://www.pearsonhighered.com/irc

Acknowledgments 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:

xxiv Preface

Haseeb Ahmed, Johnson C. Smith University

Joan Anderssen, Arapahoe Community College

Chris Armstrong, Draughons Junior College

Curtis Bacon, Southern Oregon University

Deb Bauer, University of Oregon Pat Bernson, County College of

Morris Ed Boyer, Temple University Joe Brocato, Tarleton State

University Joseph Brum, Fayetteville Technical

Community College Lawrence Byerly, Thomas More

College Juan R. Castro, LeTourneau

University Janice Caudill, Auburn University Ting-Heng Chu, East Tennessee

State University David Daglio, Newbury College Julie Dahlquist, University of Texas

at San Antonio David 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 Tampa Robert W. Everett, Lock Haven

University Cheryl Fetterman, Cape Fear

Community College David 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 College Bruce Hadburg, University of Tampa Thomas Hiebert, University of

North Carolina, Charlotte Marlin Jensen, Auburn University John Kachurick, Misericordia

University Okan Kavuncu, University of

California at Santa Cruz Gary Kayakachoian, The University

of Rhode Island David F. Kern, Arkansas State

University Brian Kluger, University of

Cincinnati Lynn Phillips Kugele, University of

Mississippi Mary LaPann, Adirondack

Community College Carlos Liard-Muriente, Central

Connecticut State University Christopher Liberty, College of Saint

Rose, Empire State College Lynda 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.

—A.J.K. / J.D.M. / J.W.P.

Y. Lal Mahajan, Monmouth University

Edmund Mantell, Pace University Peter Marks, Rhode Island College Mario Mastrandrea, Cleveland

State University Anna McAleer, Arcadia University Robert Meyer, Parkland College Ronald Moy, St. John’s University Elisa Muresan, Long Island

University Michael Nugent, Stony Brook

University Tony Plath, University of North

Carolina at Charlotte Anthony Pondillo, Siena College Walter Purvis, Coastal Carolina

Community College Emil Radosevich, Central New

Mexico Community College Deana Ray, Forsyth Technical

Community College Clarence Rose, Radford University

Ahmad Salam, Widener University Mary Schranz, University of

Wisconsin, Madison (retired) Jeffrey Schultz, Christian Brothers

University Thomas W. Secrest, Coastal

Carolina University Ken Shakoori, California State

University, Bakersfield Michael Slates, Bowling Green

State University Suresh Srivastava, University of

Alaska, Anchorage Maurry Tamarkin, Clark University Fang Wang, West Virginia

University Paul Warrick, Westwood College Jill Wetmore, Saginaw Valley State

University Kevin Yost, Auburn University Jingxue Yuan, Texas Tech

University Mengxin Zhao, Bentley College

Preface xxv

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

LO1 Identify the goal of the firm. The Goal of the Firm

LO2 Understand the basic principles of finance, their importance, and the importance of ethics and trust.

Five Principles That Form the Foundations of Finance

LO3 Describe the role of finance in business. The Role of Finance in Business

LO4 Distinguish among the dierent legal forms of business organization.

The Legal Forms of Business Organization

LO5 Explain what has led to the era of the multi- national corporation.

Finance and the Multinational Firm: The New Role

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 introducing 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.

LO1 Identify the goal of the firm.

4 PART 1 • The Scope and Environment of Financial Management

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?

LO2 Understand the basic principles of finance, their importance, and the importance of ethics and trust.

1 PRINCIPLE

CHAPTER 1 • An Introduction to the Foundations of Financial Management 5

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 one year from now because we can invest the dollar we have today to earn interest so that at the end of one year we will have more than one dollar.

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

◆ A return for delaying consumption. Why would anyone make an investment that 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.

◆ An additional return for taking on risk. Investors generally don’t like risk. Thus, 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.

2 PRINCIPLE

3 PRINCIPLE

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.

6 PART 1 • The Scope and Environment of Financial Management

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

Ex pe

ct ed

r et

ur n Additional

expected return for taking on added risk

Risk

Expected return for delaying consumption

4 PRINCIPLE

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.

CHAPTER 1 • An Introduction to the Foundations of Financial Management 7

(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, including Monsters, Inc., Finding 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 following the opening 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 more than they do.”1 This overconfidence applies to their abilities, their knowledge 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. 142.

8 PART 1 • The Scope and Environment of Financial Management

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 fail- ure. Why is this so? Because if the project isn’t successful, these agents of the share- holders may lose their jobs.

Agency problems also contributed to our recent financial crisis, with some mort- 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.

The costs associated with the agency problem are difficult to measure, but occa- 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.

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.

PRINCIPLE

agency problem problems and conflicts resulting from the separation of the management and ownership of the firm.

CHAPTER 1 • An Introduction to the Foundations of Financial Management 9

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 mortgage 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

10 PART 1 • The Scope and Environment of Financial Management

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 of cash flow). The financial fraud committed by Bernie Madoff, WorldCom, and 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 underestimation of risk). Relying on historical evidence, managers often 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.

CHAPTER 1 • An Introduction to the Foundations of Financial Management 11

◆ Forgetting Principle 4: Market Prices Are Generally Right (Ignoring the efficiency of financial markets). Huge numbers of so-called hedge funds sprang up over 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 compensation). Without doubt the subprime lending crisis had a lot to do with 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 stockholders (owners). 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

12 PART 1 • The Scope and Environment of Financial Management

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.

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 budget- ing, capital structure, and working capital management—in the chapters ahead.

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 plan- 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. 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

LO3 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.

CHAPTER 1 • An Introduction to the Foundations of Financial Management 13

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,

Board of Directors

Chief Executive Officer (CEO)

Vice President—Finance or

Chief Financial Officer (CFO) Duties: 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

Treasurer Controller

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.

14 PART 1 • The Scope and Environment of Financial Management

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.

General Partnerships In a general partnership each partner is fully responsible 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

LO4 Distinguish among 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.

CHAPTER 1 • An Introduction to the Foundations of Financial Management 15

remaining partners liable as well. The relationship among partners is dictated entirely by the partnership agreement, which may be an oral commitment or a formal document.

Limited Partnerships In addition to the general partnership, in which all partners are jointly liable without limitation, many states provide for limited partnerships. The state statutes permit one or more of the partners to have limited liability, restricted to the amount of capital invested in the partnership. Several conditions must be met to qual- ify as a limited partner. First, at least one general partner must have unlimited liabil- ity. Second, the names of the limited partners may not appear in the name of the firm. Third, the limited partners may not participate in the management of the business. Thus, a limited partnership provides limited liability for a partner who is purely an investor.

Corporations The corporation has been a significant factor in the economic development of the United States. As early as 1819, U.S. Supreme Court Chief Justice John Marshall set forth the legal definition of a corporation as “an artificial being, invisible, intangi- ble, and existing only in the contemplation of law.”2 This entity legally functions separate and apart from its owners. As such, the corporation can individually sue and be sued and purchase, sell, or own property, and its personnel are subject to crimi- nal punishment for crimes. However, despite this legal separation, the corporation is composed of owners who dictate its direction and policies. The owners elect a board of directors, whose members in turn select individuals to serve as corporate officers, including the company’s president, vice president, secretary, and trea- surer. Ownership is reflected in common stock certificates, each designating the number of shares owned by its holder. The number of shares owned relative to the total number of shares outstanding determines the stockholder’s proportionate ownership in the business. Because the shares are transferable, ownership in a cor- poration may be changed by a shareholder simply remitting the shares to a new shareholder. The shareholder’s liability is confined to the amount of the invest- ment in the company, thereby preventing creditors from confiscating stockhold- ers’ personal assets in settlement of unresolved claims. This is an extremely impor- tant advantage of a corporation. After all, would you be willing to invest in USAirways if you would be held liable if one of its planes crashed? Finally, the life of a corporation is not dependent on the status of the investors. The death or with- drawal of an investor does not affect the continuity of the corporation. Its manag- ers continue to run the corporation when stock is sold or when it is passed on through inheritance.

Organizational Form and Taxes: The Double Taxation on Dividends Historically, one of the drawbacks of the corporate form was the double taxation of dividends. This occurs when a corporation earns a profit, pays taxes on those profits (the first taxation of earnings), and pays some of those profits back to the sharehold- ers in the form of dividends, and then the shareholders pay personal income taxes on those dividends (the second taxation of those earnings). This double taxation of earn- ings does not take place with proprietorships and partnerships. Needless to say, that had been a major disadvantage of corporations.

Under the current law, qualified dividends from domestic corporations and qualified foreign corporations are now taxed at a maximum rate of 20 percent. Moreover, if your personal income puts you in the 10 percent or 15 percent

2 The Trustees of Dartmouth College v. Woodard, 4 Wheaton 636 (1819).

limited partnership a partnership in which one or more of the partners has limited liability, restricted to the amount of capital he or she invests in the partnership.

corporation an entity that legally functions separate and apart from its owners.

16 PART 1 • The Scope and Environment of Financial Management

income rate bracket, you don’t pay any taxes on your dividend income, and if you are in the 25 through 35 percent tax bracket, you pay only 15 percent on qualified dividends.

S-Corporations and Limited Liability Companies (LLCs) One of the problems that entrepreneurs and small business owners face is that they need the benefits of the corporate form to expand, but the double taxation of earn- ings that comes with the corporate form makes it difficult to accumulate the neces- sary wealth for expansion. Fortunately, the government recognizes this problem and has provided two business forms that are, in effect, crosses between a partnership and a corporation with the tax benefits of partnerships (no double taxation of earn- ings) and the limited liability benefit of corporations (your liability is limited to what you invest).

The first is the S-corporation, which provides limited liability while allowing the business’s owners to be taxed as if they were a partnership—that is, distributions back to the owners are not taxed twice as is the case with dividends distributed by regu- lar corporations. Unfortunately, a number of restrictions accompany the S-corporation that detract from the desirability of this business form. Thus, an S-corporation cannot be used for a joint venture between two corporations. As a result, this business form has been losing ground in recent years in favor of the limited liability company.

The limited liability company (LLC) is also a cross between a partnership and a corporation. Just as with the S-corporation, the LLC retains limited liability for its own- ers, but it runs and is taxed like a partnership. In general, it provides more flexibility than the S-corporation. For example, corporations can be owners in an LLC. However, because LLCs operate under state laws, both states and the IRS have rules for what qualifies as an LLC, and different states have different rules. But the bottom line in all this is that the LLC must not look too much like a corporation or it will be taxed as one.

Which Organizational Form Should Be Chosen? Owners of new businesses have some important decisions to make in choosing an organizational form. Whereas each business form seems to have some advantages over the others, the advantages of the corporation begin to dominate as the firm grows and needs access to the capital markets to raise funds. Table 1-1 provides a summary of the differences among the major organizational forms.

TABLE 1-1 The Different Business Organizational Forms

Number of Owners Liability for Firm’s Debts

Change in Ownership Dissolves the Firm Taxation

Sole Proprietorship One Yes Yes Personal Types of Partnerships

• General Partnership No limit Each partner is liable for the entire amount

Yes Personal

• Limited Partnership At least one general partner (GP), no limit on limited partners (LP)

GP—Yes LP—No

Personal

Types of Corporations

• Corporation No limit No No Both corporate and personal taxes

• S-corporation Maximum of 100 No No Personal

Limited Liability Company

No limit No No Personal

S-corporation a corporation that, because of specific qualifications, is taxed as though it were a partnership.

limited liability company (LLC) a cross between a partnership and a corporation under which the owners retain limited liability but the company is run and is taxed like a partnership.

CHAPTER 1 • An Introduction to the Foundations of Financial Management 17

Because of the limited liability, the ease of transferring ownership through the sale of common shares, and the flexibility in dividing the shares, the corporation is the ideal business entity in terms of attracting new capital. In contrast, the unlimited liabilities of the sole proprietorship and the general partnership are deterrents to raising equity capital. Between the extremes, the limited partnership does provide limited liability for limited partners, which has a tendency to attract wealthy inves- tors. However, the impracticality of having a large number of partners and the restricted marketability of an interest in a partnership prevent this form of organiza- tion from competing effectively with the corporation. Therefore, when developing our decision models, we assume we are dealing with the corporate form and corpo- rate tax codes.

Concept Check 1. What are the primary differences among a sole proprietorship, a partnership, and a

corporation? 2. Explain why large and growing firms tend to choose the corporate form. 3. What is an LLC?

Finance and the Multinational Firm: The New Role In the search for profits, U.S. corporations have been forced to look beyond our country’s borders. This movement was spurred on by the collapse of communism and the acceptance of the free market system in Third World countries. All this has taken place at a time when information technology has experienced a revolution brought on by the personal computer and the Internet. Concurrently, the United States went through an unprecedented period of deregulation of industries. These changes resulted in the opening of new international markets, and U.S. firms experienced a period of price competition here at home that made it imperative that businesses look across borders for investment opportunities. The end result is that many U.S. companies, including General Electric, IBM, Walt Disney, and American Express, have restructured their operations to expand internationally. The bottom line is that what you think of as a U.S. firm may be much more of a multinational firm than you would expect. For example, Coca-Cola earns around 60 percent of its profits from overseas sales, and this is not uncommon for numer- ous U.S. firms.

Just as U.S. firms have ventured abroad, foreign firms have also made their mark in the United States. You need only look to the auto industry to see what effects the entrance of Toyota, Honda, Nissan, BMW, and other foreign car manufacturers has had on the industry. In addition, foreigners have bought and now own such compa- nies as Brooks Brothers, RCA, Pillsbury, A&P, 20th Century Fox, Columbia Pictures, and Firestone Tire & Rubber. Consequently, even if we wanted to, we couldn’t keep all our attention focused on the United States, and even more important, we wouldn’t want to ignore the opportunities that are available across international borders.

Concept Check 1. What has brought on the era of the multinational corporation? 2. Has looking beyond U.S. borders been a profitable experience for U.S. corporations?

LO5 Explain what has led to the era of the multinational corporation.

18 PART 1 • The Scope and Environment of Financial Management

Chapter Summaries

Identify the goal of the firm. (pgs. 3–4)

SUMMARY: This chapter outlines the framework for the maintenance and creation of shareholder wealth, which should be the goal of the firm and its managers. The goal of maximization of shareholder wealth is chosen because it deals well with uncertain- ty and time in a real-world environment. As a result, the maximization of shareholder wealth is found to be the proper goal for the firm.

Understand the basic principles of finance, their importance, and the importance of ethics and trust. (pgs. 4–12)

SUMMARY: The five basic principles of finance are:

1. Cash Flow Is What Matters—Incremental cash received, not accounting profits, drives value.

2. Money Has a Time Value—A dollar received today is more valuable to the recip- ient than a dollar received in the future.

3. Risk Requires a Reward—The greater the risk of an investment, the higher will be the investor’s required rate of return, and, other things remaining the same, the lower will be the investment’s value.

4. Market Prices Are Generally Right—For example, product market prices are often slower to react to important news than are prices in financial markets, which tend to be very efficient and quick to respond to news.

5. Conflicts of Interest Cause Agency Problems—Large firms are typically run by professional managers who own a small fraction of the firms’ equity. The indi- vidual actions of these managers are often motivated by self-interest, which may result in managers not acting in the best interests of the firm’s owners. When this happens, the firm’s stock will lose value.

Though not one of the five principles of finance, ethics and trust are also essential elements of the business world, and without them, nothing works.

KEY TERMS

LO1

LO2

Incremental cash flow, page 5 the difference between the cash flows a company will pro- duce both with and without the investment it is thinking about making.

Opportunity cost, page 5 the cost of making a choice in terms of the next best alternative that must be foregone.

Efficient market, page 6 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.

Agency problem, page 8 problems and conflicts resulting from the separation of the management and ownership of the firm.

Describe the role of finance in business. (pgs. 12–14)

SUMMARY: Finance is the study of how people and businesses evaluate investments and raise capital to fund them. The three basic types of issues addressed by the study of finance are: (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.

LO3

CHAPTER 1 • An Introduction to the Foundations of Financial Management 19

Distinguish among the different legal forms of business organization. (pgs. 14–17)

SUMMARY: The legal forms of business are examined. The sole proprietorship is a business operation owned and managed by an individual. Initiating this form of business is simple and generally does not involve any substantial organizational costs. The proprietor has complete control of the firm but must be willing to assume full responsibility for its outcomes.

The general partnership, which is simply a coming together of two or more indi- viduals, is similar to the sole proprietorship. The limited partnership is another form of partnership sanctioned by states to permit all but one of the partners to have lim- ited liability if this is agreeable to all partners.

The corporation increases the flow of capital from public investors to the business community. Although larger organizational costs and regulations are imposed on this legal entity, the corporation is more conducive to raising large amounts of capi- tal. Limited liability, continuity of life, and ease of transfer in ownership, which increase the marketability of the investment, have contributed greatly in attracting large numbers of investors to the corporate environment. The formal control of the corporation is vested in the parties who own the greatest number of shares. However, day-to-day operations are managed by the corporate officers, who theoretically serve on behalf of the firm’s stockholders.

KEY TERMS

LO4

Capital budgeting, page 12 the decision- making process with respect to investment in fixed assets.

Capital structure decisions, page 12 the decision-making process with funding choices and the mix of long-term sources of funds.

Working capital management, page 12 the management of the firm’s current assets and short-term financing.

Financial markets, page 13 those institu- tions and procedures that facilitate transac- tions in all types of financial claims.

Sole proprietorship, page 14 a business owned by a single individual.

Partnership, page 14 an association of two or more individuals joining together as co-owners to operate a business for profit.

General partnership, page 14 a partnership in which all partners are fully liable for the indebtedness incurred by the partnership.

Limited partnership, page 15 a partnership in which one or more of the partners has limited liability, restricted to the amount of capital he or she invests in the partnership.

Corporation, page 15 an entity that legally functions separate and apart from its owners.

S-corporation, page 16 a corporation that, because of specific qualifications, is taxed as though it were a partnership.

Limited liability company (LLC), page 16 a cross between a partnership and a corpora- tion under which the owners retain limited liability but the company is run and is taxed like a partnership.

Explain what has led to the era of the multinational corporation. (pg. 17)

SUMMARY: With the collapse of communism and the acceptance of the free market system in Third World countries, U.S. firms have been spurred on to look beyond their own boundaries for new business. The end result has been that it is not un- common for major U.S. companies to earn over half their income from sales abroad. Foreign firms are also increasingly investing in the United States.

LO5

KEY TERMS

20 PART 1 • The Scope and Environment of Financial Management

Review Questions All Review Questions are available in MyFinanceLab.

1-1. What are some of the problems involved in implementing the goal of maximiza- tion of shareholder wealth? 1-2. Firms often involve themselves in projects that do not result directly in prof- its. For example, Apple, which we featured in the chapter introduction, donated $50 million to Stanford University hospitals and another $50 million to the African aid organization (Product) RED, a charity fighting against AIDS, tuberculosis, and malaria. Do these projects contradict the goal of maximization of shareholder wealth? Why or why not? 1-3. What is the relationship between financial decision making and risk and return? Would all financial managers view risk–return trade-offs similarly? 1-4. What is the agency problem, and how might it impact the goal of maximization of shareholder wealth? 1-5. Define (a) sole proprietorship, (b) partnership, and (c) corporation. 1-6. Identify the primary characteristics of each form of legal business organization. 1-7. Using the following criteria, specify the legal form of business that is favored: (a) organizational requirements and costs, (b) liability of the owners, (c) the continu- ity of the business, (d) the transferability of ownership, (e) management control and regulations, (f) the ability to raise capital, and (g) income taxes. 1-8. There are a lot of great business majors. Check out the Careers in Business web- site at www.careers-in-business.com. It covers not only finance but also marketing, accounting, and management. Find out about and provide a short write-up describ- ing the opportunities investment banking and financial planning offer. 1-9. Like it or not, ethical problems seem to crop up all the time in finance. Some of the worst financial scandals are examined at http://projects.exeter.ac.uk/RDavies/ arian/scandals/classic.html. Take a look at the write-ups dealing with “The Credit Crunch,” “The Dot-Com Bubble and Investment Banks,” and “Bernard L. Madoff Investment Securities.” Provide a short write-up on these events. 1-10. We know that if a corporation is to maximize shareholder wealth, the interests of the managers and the shareholders must be aligned. The simplest way to align these interests is to structure executive compensation packages appropriately to encourage managers to act in the best interests of shareholders through stock and option awards. However, has executive compensation gotten out of control? Take a look at the Executive Pay Watch website at www.aflcio.org/corporatewatch/pay- watch to see to whom top salaries have gone (click on “100 Highest” after scrolling down to the very bottom of the page). What are the most recent total compensation packages for the head of Oracle (ORCL), CBS Corporation (CBS), Disney (DIS), and ExxonMobil (XOM)?

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

http://projects.exeter.ac.uk/RDavies/arian/scandals/classic.html

http://www.aflcio.org/corporatewatch/pay-watch

CHAPTER 1 • An Introduction to the Foundations of Financial Management 21

Mini Case This Mini Case is available in MyFinanceLab.

The final stage in the interview process for an assistant financial analyst at Caledonia Products involves a test of your understanding of basic financial concepts. You are given the following memorandum and asked to respond to the questions. Whether you are offered a position at Caledonia will depend on the accuracy of your response.

To: Applicants for the position of Financial Analyst From: Mr. V. Morrison, CEO, Caledonia Products Re: A test of your understanding of basic financial concepts and of the corporate tax code

Please respond to the following questions: a. What is the appropriate goal for the firm and why? b. What does the risk–return trade-off mean? c. Why are we interested in cash flows rather than accounting profits in deter-

mining the value of an asset? d. What is an efficient market, and what are the implications of efficient markets

for us? e. What is the cause of the agency problem, and how do we try to solve it? f. What do ethics and ethical behavior have to do with finance? g. Define (1) sole proprietorship, (2) partnership, and (3) corporation.

Back in 1995, when they first met, Larry Page and Sergey Brin were not particularly fond of one another. Larry was on a weekend visit to Stanford University, and Sergey was in a group of students assigned to show him around. Nonetheless, in short time the two began to collaborate and even built their own computer housings in Larry’s dorm room. That computer housing later became Google’s first data center. From there things didn’t move as smoothly as one might expect; there just wasn’t the interest from the search-engine players of the day, so Larry and Sergey decided to go it alone. Stuck in a dorm room with maxed-out credit cards, the problem they faced was money— they didn’t have any. So they put together a business plan and went looking for money. Fortunately for all of us who use Google today, they met up with one of the founders of Sun Microsystems, and after a short demo he had to run off somewhere and upon leav- ing said, “Instead of us discussing all the details, why don’t I just write you a check?" It was made out to Google Inc. and was for $100,000.

With that, Google Inc. (GOOGL) was founded, and over the next 10 years it became anything but a conventional company, with an official motto of “don’t be evil”; a goal to make the world a better place; on-site meals prepared by a former caterer for the Grateful Dead; lava lamps; and a fleet of Segways to move employees about the

CHAPTER

2 The Financial Markets and Interest Rates

Learning Objectives

LO1 Describe key components of the U.S. financial market system and the financing of business.

Financing of Business: The Movement of Funds Through the Economy

LO2 Understand how funds are raised in the capital markets.

Selling Securities to the Public

LO3 Be acquainted with recent rates of return. Rates of Return in the Financial Markets

LO4 Explain the fundamentals of interest rate determination and the popular theories of the term structure of interest rates.

Interest Rate Determinants in a Nutshell

Google campus to roller-hockey games in the parking lot and to other on-site diversions. It was not unexpected that when Google needed more money in 2004, it would raise that money in an unusual way—it would sell shares of stock through a “Dutch auction.” With a Dutch auction investors submit bids, say- ing how many shares they’d like and at what price. Next, Google used these bids to calculate an issue price that was just low enough to ensure that all the shares were sold, and everyone who bid at least that price got to buy shares at the issue price.

Eventually, Google settled on an issue price of $85 per share, and on August 19, 2004, it raised $1.76 billion. How did those initial investors do? On the first day of trading, Google’s shares rose by 18 percent, and by mid-March 2005 the price of Google stock had risen to about $340 per share! In September 2005, Google went back to the financial markets and sold another 14.18 million shares at $295 per share, and by July 2015 Google stock was selling at around $544 per share.

In addition to issuing common stock, many firms also issue debt. In fact, in 2015 both Apple (APPL) and Netflix (NFLX) raised money by selling corporate bonds— Apple selling $6.5 billion worth of them and Netflix selling $1.5 billion worth of them.

As you read this chapter , you will learn about how funds are raised in the finan- cial markets. This will help you, as an emerging business executive specializing in accounting, finance, marketing, or strategy, understand the basics of acquiring finan- cial capital in the funds marketplace.

Long-term sources of financing, such as bonds and common stock, are raised in the capital markets. By the term capital markets, we mean all the financial institutions that help a business raise long-term capital, where “long term” is defined as a security with a maturity date of more than 1 year. After all, most companies are in the business of sell- ing products and services to their customers and do not have the expertise on their own to raise money to finance the business. Examples of these financial institutions that you may have heard of would include Bank of America (BAC), Goldman Sachs (GS), Citigroup (C), Morgan Stanley (MS), UBS AG (UBS), and Deutsche Bank (DB).

This chapter focuses on the procedures by which businesses raise money in the capital markets. It helps us understand how the capital markets work. We will intro- duce the logic of how investors determine their required rate of return for making an investment. In addition, we will study the historical rates of return in the capital markets so that we have a perspective on what to expect. This knowledge of financial market history will permit you as both a financial manager and an investor to realize that earning, say, a 40 percent annual return on a common stock investment does not occur very often.

As you work through this chapter, be on the lookout for direct applications of several of our principles from Chapter 1 that form the basics of business financial management. Specifically, your attention will be directed to Principle 3: Risk Requires a Reward and Principle 4: Market Prices Are Generally Right.

capital markets all institutions and procedures that facilitate transactions in long-term financial instruments.

24 PART 1 • The Scope and Environment of Financial Management

Financing of Business: The Movement of Funds Through the Economy Financial markets play a critical role in a capitalist economy. In fact, when money quit flowing through the financial markets in 2008, our economy ground to a halt. When our economy is healthy, funds move from saving-surplus units—that is, those who spend less money than they take in—to savings-deficit units—that is, those who have a need for additional funding. What are some examples of savings-deficit units? Our federal government, which is running a huge deficit, takes much less in from taxes than it is spending. Hulu, the online video service, would like to build new facilities but does not have the $50 million it needs to fund the expansion. Rebecca Swank, the sole proprietor of the Sip and Stitch, a yarn and coffee shop, would like to open a second store but needs $100,000 to finance a second shop. Emily and Michael Dimmick would like to buy a house for $240,000 but have only $50,000 saved up. In these cases, our government, a large company, a small business owner, and a family are all in the same boat—they would like to spend more than they take in.

Where will this money come from? It will come from savings-surplus units in the economy—that is, from those who spend less than they take in. Examples of savings- surplus units might include individuals, companies, and governments. For example, John and Sandy Randolph have been saving for retirement and earn $10,000 more each year than they spend. In addition, the firm John works for contributes $5,000 every year to his retirement plan. Likewise, ExxonMobil (XOM) generates about $50 billion in cash annually from its operations and invests about half of that on new exploration—the rest is available to invest. Also, a number of governments around the world bring in more money than they spend—countries like China, the United Arab Emirates, and Saudi Arabia.

Now let’s take a look at how savings are transferred to those who need the money. Actually, there are three ways that savings can be transferred through the financial markets to those in need of funds (see Figure 2-1).

LO1 Describe key components of the U.S. financial market system and the financing of business.

FIGURE 2-1 Three Ways to Transfer Capital in the Economy

1 Direct transfer of funds

2 Indirect transfer using the investment banker

3 Indirect transfer using the financial intermediary

The business firm (a savings-deficit unit)

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's se

cu rit

ie s

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ia rie

s in

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Sa ve

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The business firm (a savings-deficit unit)

Investment- banking firm

Financial intermediary

Sa ve

rs in

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Savers (savings- surplus units)

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ia ry

's se

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ie s

Savers (savings- surplus units)

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is su

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ec ur

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Savers (savings- surplus units)

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in th

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si ne

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CHAPTER 2 • The Financial Markets and Interest Rates 25

Let’s take a closer look at these three methods:

1. Direct transfer of funds Here the firm seeking cash sells its securities directly to savers (investors) who are willing to purchase them in hopes of earning a large return. A start-up company is a good example of this process at work. The new business may go directly to a wealthy private investor called an angel investor or business angel for funds, or it may go to a venture capitalist for early funding. That’s how Koofers.com got up and running. The founders of Koofers were stu- dents at Virginia Tech who put together an interactive website that provides a place for students to share class notes and course and instructor ratings/grade distributions, along with study guides and past exams. The website proved to be wildly popular, and in 2009 it received $2 million of funding from two venture capitalists to expand, who, in return, received part ownership of Koofers.

2. Indirect transfer using an investment-banking firm An investment-banking firm is a financial institution that helps companies raise capital, trades in securi- ties, and provides advice on transactions such as mergers and acquisitions. In helping firms raise capital, an investment banker frequently works together with other investment bankers in what is called a syndicate. The syndicate will buy the entire issue of securities from the firm that is in need of financial capital. The syndicate will then sell the securities at a higher price to the investing pub- lic (the savers) than it paid for them. Morgan Stanley and Goldman Sachs are examples of banks that perform investment-banking duties. Notice that under this second method of transferring savings, the securities being issued just pass through the investment-banking firm. They are not transformed into a different type of security.

3. Indirect transfer using a financial intermediary This is the type of system in which life insurance companies, mutual funds, and pension funds operate. The financial intermediary collects the savings of individuals and issues its own (indirect) securities in exchange for these savings. The intermediary then uses the funds collected from the individual savers to acquire the business firm’s (direct) securities, such as stocks and bonds.

A good financial system is one that efficiently takes money from savers and gets it to the individuals who can best put that money to use, and that’s exactly what our system does. This may seem like common sense, but it is not necessarily com- mon across the world. In spite of the fact that the U.S. financial system recently experienced some problems, it provides more choices for both borrowers and sav- ers than most other financial systems, and so it does a better job of allocating capi- tal to those who can more productively use it. As a result, we all benefit from the three transfer mechanisms displayed in Figure 2-1, and capital formation and eco- nomic wealth are greater than they would be in the absence of this financial market system.

There are numerous ways to classify the financial markets. These markets can take the form of anything from an actual building on Wall Street in New York City to an electronic hookup among security dealers all over the world. Let’s take a look at five sets of dichotomous terms that are used to describe the financial markets.

Public Offerings Versus Private Placements When a corporation decides to raise external capital, those funds can be obtained by making a public offering or a private placement. In a public offering, both individual and institutional investors have the opportunity to purchase the securities. The securities are usually made available to the public at large by an investment-banking firm, which is a firm that specializes in helping other firms raise money. This process of acting as an intermediary between an issuer of a security and the investing public is called underwriting, and the investment firm that does this is referred to as an

venture capitalist an investment firm (or individual investor) that provides money to business start-ups.

angel investor a wealthy private investor who provides capital for a business start-up.

public offering a security offering in which all investors have the opportunity to acquire a portion of the financial claims being sold.

26 PART 1 • The Scope and Environment of Financial Management

underwriter. This is a very impersonal market, and the issuing firm never actually meets the ultimate purchasers of the securities.

In a private placement, also called a direct placement, the securities are offered and sold directly to a limited number of investors. The firm will usually hammer out, on a face-to-face basis with the prospective buyers, the details of the offering. In this set- ting, the investment-banking firm may act as a finder by bringing together potential lenders and borrowers. The private placement market is a more personal market than its public counterpart.

A venture capital firm is an example of investors who are active in the private placement market. A venture capital firm first raises money from institutional investors and high net worth individuals, then pools the funds and invests in start-ups and early-stage companies that have high-return potential but are also very risky investments. These companies are not appealing to the broader public markets owing to their (1) small absolute size, (2) very limited or nonexistent historical track record of operating results, (3) obscure growth prospects, and (4) inability to sell the stock easily or quickly. Most venture capitalists invest for 5 to 7 years, in the hopes of selling the firms or taking them public through an initial public offering.

Because of the high risk, the venture capitalist will occupy a seat or seats on the young firm’s board of directors and will take an active part in monitoring the com- pany’s management activities. This situation should remind you of Principle 3: Risk Requires a Reward.

Primary Markets Versus Secondary Markets A primary market is a market in which new, as opposed to previously issued, securities are traded. For example, if Google issues a new batch of stock, this issue would be considered a primary market transaction. In this case, Google would issue new shares of stock and receive money from investors. The primary market is akin to the new car market. For example, the only time that Ford ever gets money for selling a car is the first time the car is sold to the public. The same is true with securities in the primary market. That’s the only time the issuing firm ever gets any money for the securities, and it is the type of transaction that introduces new financial assets— for example, stocks and bonds—into the economy. The first time a company issues stock to the public is referred to as an initial public offering or IPO. For example, this is what Alibaba (BABA), the Chinese e-commerce company, did in September of 2014 when it first issued common stock to the public, becoming the biggest IPO of all time with a $25 billion IPO. This is also what happened with Google on August 19, 2004, when it first sold its common stock to the public at $85 per share and raised $1.76 billion. When Google went back to the primary market in September 2005 and sold more Google stock, worth an additional $4.18 billion, it was considered a seasoned equity offering, or SEO. A seasoned equity offering is the sale of addi- tional shares by a company whose shares are already publicly traded and is also called a secondary share offering.

The secondary market is where currently outstanding securities are traded. You can think of it as akin to the used car market. If a person who bought some shares of the Google stock subsequently sells them, he or she does so in the secondary market. Those shares can go from investor to investor, and Google never receives any money when they are traded. In effect, all transactions after the initial purchase in the pri- mary market take place in the secondary market. These sales do not affect the total amount of financial assets that exists in the economy.

The job of regulating the primary and secondary markets falls on the Security and Exchange Commission, or SEC. For example, before a firm can offer its securities for sale in the primary markets, it must register them with the SEC, and it is the job of the SEC to make sure that the information provided to investors is adequate and accu- rate. The SEC also regulates the secondary markets, making sure that investors are provided with enough accurate information to make intelligent decisions when buy- ing and selling in the secondary markets.

3 PRINCIPLE

private placement a security offering limited to a small number of potential investors.

primary market a market in which securities are offered for the first time for sale to potential investors.

initial public offering (IPO) the first time a company issues its stock to the public.

seasoned equity offering (SEO) the sale of additional stock by a company whose shares are already publicly traded.

secondary market a market in which currently outstanding securities are traded.

CHAPTER 2 • The Financial Markets and Interest Rates 27

The Money Market Versus the Capital Market The key feature distinguishing the money and capital mar- kets is the maturity period of the securities traded in them. The money market refers to transactions in short-term debt instruments, with “short-term” meaning maturity periods of 1 year or less. Short-term securities are generally issued by borrowers with very high credit ratings. The major instruments issued and traded in the money market are U.S. Treasury bills, various federal agency securities, bank- ers’ acceptances, negotiable certificates of deposit, and com- mercial paper. Stocks, either common or preferred, are not traded in the money market. Keep in mind that the money market isn’t a physical place. You do not walk into a build- ing on Wall Street that has the words “Money Market” etched in stone over its arches. Rather, the money market is primarily a telephone and computer market.

As we explained, the capital market refers to the market for long-term financial instruments. “Long-term” here means having maturity periods that extend beyond 1 year. In the broad sense, this encompasses term loans, financial leases, and corporate stocks and bonds.

Spot Markets Versus Futures Markets Cash markets are markets in which something sells today, right now, on the spot—in fact, cash markets are often called spot markets. Futures markets are markets in which you can buy or sell something at some future date—in effect, you sign a contract that states what you’re buying, how much of it you’re buying, at what price you’re buying it, and when you will actually make the purchase. The difference between purchasing something in the spot market and purchasing it in the futures market is when it is delivered and when you pay for it. For example, say it is May right now and you need 250,000 euros in December. You could purchase 125,000 euros today in the spot market and another 125,000 euros in the futures market for delivery in December. You get the euros you purchased in the spot market today, and you get the euros you purchased in the futures market seven months later.

Stock Exchanges: Organized Security Exchanges Versus Over-the-Counter Markets, a Blurring Difference Many times markets are differentiated as being organized security exchanges or over-the-counter markets. Because of the technological advances over the past 10 years coupled with deregulation and increased competition, the difference between an organized exchange and the over-the-counter market has been blurred. Still, these remain important elements of the capital markets. Organized security exchanges are tangible entities; that is, they physically occupy space (such as a building or part of a building), and financial instruments are traded on their prem- ises. The over-the-counter markets include all security markets except the orga- nized exchanges. The money market, then, is an over-the-counter market because it doesn’t occupy a physical location. Because both markets are important to financial officers concerned with raising long-term capital, some additional discussion is warranted.

Today, the mechanics of trading have changed dramatically, and 80 to 90 percent of all trades are done electronically, blurring the difference between trading on an organized exchange versus trading on the over-the-counter market. Even if your stock is listed on the New York Stock Exchange (NYSE), the odds are that it won’t be

REMEMBER YOUR PRINCIPLES In this chapter, we cover material that introduces the financial manager to the process involved in raising funds in the nation’s capital markets and to the way interest rates in those markets are determined.

Without question the United States has a highly devel- oped, complex, and competitive system of financial markets that allows for the quick transfer of savings from people and organizations with a surplus of savings to those with a savings deficit. Such a system of highly developed financial markets allows great ideas (such as the personal computer) to be financed and increases the overall wealth of the economy. Consider your wealth, for example, compared to that of the average family in Russia. Russia lacks the complex system of financial markets to facilitate securities transactions. As a result, real capital formation there has suffered.

Thus, we return now to Principle 4: Market Prices Are Generally Right. Financial managers like the U.S. system of capital markets because they trust it. This trust stems from the fact that the markets are efficient, and so prices quickly and accurately reflect all available information about the value of the underlying securities. This means that the expected risks and expected cash flows matter more to market participants than do simpler things such as accounting changes and the sequence of past price changes in a specific security. With security prices and returns (such as interest r