Foundations ofFinancial ManagementTHIRTEENTH EDITION

STANLEY B. BLOCKTexas Christian University

GEOFFREY A. HIRTDePaul University

BARTLEY R. DANIELSENNorth Carolina State University

McGraw-HillIrwln

Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis :

Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico CityMilan Montreal New Delhi Santiago Seoul Singapore Sydney • Taipei ' Toronto

ContentsPART1 ! INTRODUCTION

1 The Goals and Functions of FinancialManagement 4The Field of Finance 5Evolution of the Field of Finance 5

Modern Issues in Finance 6The Impact of the Internet 6

Functions of Financial Management 7Forms of Organization 8

Sole Proprietorship 8Partnership 8Corporation 9

Corporate Governance 10Sarbanes-Oxley Act 11

Goals of Financial Management 11A Valuation Approach 12Maximizing Shareholder Wealth 12Management and Stockholder Wealth 13Social Responsibility and EthicalBehavior 13

The Role of the Financial Markets 75Structure and Functions of the FinancialMarkets 15Allocation of Capital 16Institutional Pressure on Public Companiesto Restructure 17Internationalization of the FinancialMarkets 17The Internet and Changes in the CapitalMarkets 18

Format of the Text 19Parts 19

1. Introduction 192. Financial Analysis andPlanning 193. Working Capital Management 194. The Capital Budgeting Process 205. hong-Term Financing 206. Expanding the Perspective ofCorporate Finance 20

List of Terms 20Discussion Questions 21Web Exercise 21

1 FINANCIAL ANALYSIS AND PLANNING

2 Review of Accounting 26Income Statement 27

Return to Capital 28Price-Earnings Ratio Applied to Earningsper Share 28Limitations of the Income Statement 29

Balance Sheet 30Interpretation of Balance Sheet Items 30Concept of Net Worth 32Limitations of the Balance Sheet 32

Statement of Cash Flows 33Developing an Actual Statement 34Determining Cash Flows from OperatingActivities 34Determining Cash Flows from InvestingActivities 36Determining Cash Flows from FinancingActivities 36Combining the Three Sections of theStatement 38

Depreciation and Funds Flow 39Free Cash Flow 39Income Tax Considerations 40

Corporate Tax Rates 41Cost of a Tax-Deductible Expense 42Depreciation as a Tax Shield 42

Summary 43List of Terms 44Discussion Questions 44Practice Problems and Solutions 44Problems 45Web Exercise 53S&P Problems 53

3 Financial Analysis 55Ratio Analysis 56

Classification System 57The Analysis 58

A. Profitability Ratios 58B. Asset Utilization Ratios 61C. Liquidity Ratios 62-D. Debt Utilization Ratios 62

XIX

XX Contents

Trend Analysis 63Impact of Inflation on FinancialAnalysis 67

An Illustration 67Disinflation Effect 68

Deflation 69Other Elements of Distortion in ReportedIncome 69

Explanation of Discrepancies 69Sales 70Cost of Goods Sold 70Extraordinary Gains/Losses 70

Net Income 71Summary 72List of Terms 72Discussion Questions 72Practice Problems and Solutions 73Problems 76Comprehensive Problems 87Web Exercise 92S&P Problems 92

4 Financial Forecasting 94Constructing Pro FormaStatements 95Pro Forma Income Statement 95

Establish a Sales Projection 96Determine a Production Schedule and theGross Profit 96

Cost of Goods Sold 98Other Expense Items 99Actual Pro Forma Income Statement 99

Cash Budget 100Cash Receipts 100Cash Payments 101Actual Budget 102

Pro Forma Balance Sheet 103Explanation of Pro Forma BalanceSheet 105Analysis of Pro Forma Statement 106

Percent-of-Sales Method 706Summary 108List of Terms 109Discussion Questions 109Practice Problems and Solutions 109Problems 111Comprehensive Problems 118Web Exercise 121

5 Operating and Financial Leverage 122Leverage in a Business 123Operating Leverage 123

Break-Even Analysis 123A More Conservative Approach 725The Risk Factor 727Cash Break-Even Analysis 727Degree of Operating Leverage 72S

Leveraged Firm 128Conservative Firm 129

Limitations of Analysis 729Financial Leverage 130

Impact on Earnings 131Degree of Financial Leverage 737

Plan A (Leveraged) 133Plan B (Conservative) 134

Limitations to Use of FinancialLeverage 134

Combining Operating and FinancialLeverage 134Degree of Combined Leverage 756"

A Word of Caution 138Summary 138Review of Formulas 138List of Terms 139Discussion Questions 139Practice Problems and Solutions 140Problems 141Comprehensive Problem 149Web Exercise 151S&P Problems 151

PART 3 ! WORKING CAPITAL MANAGEMENT

6 Working Capital and the FinancingDecision 156The Nature of Asset Growth 158Controlling Assets—Matching Sales andProduction 755

Temporary Assets under LevelProduction—An Example 762

Patterns of Financing 767Alternative Plans 168Long-Term Financing 765Short-Term Financing(Opposite Approach) 769

The Financing Decision 769Term Structure of Interest Rates 7 77

Contents XXI

A Decision Process 774Introducing Varying Conditions 175Expected Value 775

Shifts in Asset Structure 7 76Toward an Optimal Policy 777Summary 179List of Terms 179Discussion Questions 180Practice Problems and Solutions 180Problems 181Web Exercise 187S&P Problems 187

7 Current Asset Management 189Cash Management 190

Reasons for Holding Cash Balances 790Cash Flow Cycle 790

Collections and Disbursements 193Float 794Improving Collections 794Extending Disbursements 794Cost-Benefit Analysis 795Electronic Funds Transfer 795International Cash Management 797

Marketable Securities 798Management of Accounts Receivable 202

Accounts Receivable as anInvestment 202Credit Policy Administration 202

Credit Standards 202Terms of Trade 204Collection Policy 206

An Actual Credit Decision 207Inventory Management 208

Level versus Seasonal Production 208Inventory Policy in Inflation (andDeflation) 209The Inventory Decision Model 209

Carrying Costs 209Ordering Costs 209

Economic Ordering Quantity 270Safety Stock and Stockouts 277Just-in-Time Inventory Management 272

Cost Savings from Lower Inventory 212Other Benefits 213The Downside of JIT 213

Summary 214List of Terms 215

Discussion Questions 216Practice Problems and Solutions 216Problems 217Comprehensive Problem 222Web Exercise 223

8 Sources of Short-Term Financing 224Trade Credit 225

Payment Period 225Cash Discount Policy 225Net Credit Position 226

Bank Credit 226

Prime Rate and LIBOR 22 7Compensating Balances 228Maturity Provisions 229Cost of Commercial Bank Financing 230Interest Costs with CompensatingBalances 230Rate on Installment Loans 231Annual Percentage Rate 231The Credit Crunch Phenomenon 232

Financing through Commercial Paper 233

Advantages of Commercial Paper 234Limitations on the Issuance of CommercialPaper 235

Foreign Borrowing 236Use of Collateral in Short-TermFinancing 236Accounts Receivable Financing 237

Pledging Accounts Receivable 237Factoring Receivables 237Asset-Backed Public Offerings 238

Inventory Financing 239Stages of Production 240Nature of Lender Control 240

Blanket Inventory Liens 240Trust Receipts 240Warehousing 240

Appraisal of Inventory ControlDevices 240

Hedging to Reduce Borrowing Risk 247Summary 243List of Terms 244Discussion Questions 244Practice Problems and Solutions 245Problems 246Comprehensive Problem 250Web Exercise 251

XX11 Contents

PART 4 I THE CAPITAL BUDGETING PROCESS

9 The Time Value of Money 255Relationship to the Capital OutlayDecision 256Future Value—Single Amount 256Present Value—Single Amount 257Future Value—Annuity 258Present Value—Annuity 260Graphical Presentation of Time ValueRelationships 262

The Relationship between Present Valueand Future Value 262The Relationship between the PresentValue of a Single Amount and the PresentValue of an Annuity 265Future Value Related to the Future Valueof an Annuity 267

Determining the Annuity Value 268Annuity Equaling a Future Value 268Annuity Equaling a Present Value 268

Determining the Yield on anInvestment 270

Yield—Present Value of a SingleAmount 270Yield—Present Value of an Annuity ' 277

Special Considerations in Time ValueAnalysis 272

Patterns of Payment 272Special Review of the Chapter 274List of Terms 276Discussion Questions 276Practice Problems and Solutions 277Problems 278Comprehensive Problem 284

10 Valuation and Rates of Return 285Valuation Concepts 286Valuation of Bonds 286

Present Value of InterestPayments 287Present Value of Principal Payment(Par Value) at Maturity 287

Concept of Yield to Maturity 288Changing the Yield to Maturity and theImpact on Bond Valuation 290

Increase in Inflation Premium 290Decrease in Inflation Premium 290

Time to Maturity 292Determining Yield to Maturity from theBond Price 292

A 13 Percent Discount Rate 293A 12 Percent Discount Rate 294Formula for Bond Yield 294

Semiannual Interest and BondPrices 295

Valuation and Preferred Stock 296Determining the Required Rateof Return (Yield) from the MarketPrice 298

Valuation of Common Stock 298No Growth in Dividends 299Constant Growth in Dividends 299

Stock Valuation Based on FutureStock Value 301

Determining the Required Rate of Returnfrom the Market Price 507The Price-Earnings Ratio Concept andValuation 302Variable Growth in Dividends 305

Summary and Review of Formulas 306Bonds 306Preferred Stock 307Common Stock 307

List of Terms 308Discussion Questions 308Practice Problems and Solutions 309Problems 310Comprehensive Problem 316Web Exercise 317Appendix 10A The Bond Yield to MaturityUsing Interpolation 318Appendix 10B Using Calculators forFinancial Analysis 319Appendix IOC Valuation of a SupernormalGrowth Firm 328

11 Cost of Capital 331The Overall Concept 332Cost of Debt 332Costs of Preferred Stock 335Cost of Common Equity 335

Valuation Approach 336Required Return on CommonStock Using the Capital AssetPricing Model 336Cost of Retained Earnings 337Cost of New Common Stock 339Overview of Common Stock Costs 339

Optimal Capital Structure—WeightingCosts 340

Contents xxiii

Capital Acquisition and InvestmentDecision Making 342

Cost of Capital in the Capital BudgetingDecision 342

The Marginal Cost of Capital 344Summary 349Review of Formulas 350List of Terms 350Discussion Questions 351Practice Problems and Solutions 351Problems 354Comprehensive Problems 361Web Exercise 363S&P Problems 363Appendix 11A Cost of Capital andthe Capital Asset Pricing Model(Optional) 364

12 The Capital Budgeting Decision 371Administrative Considerations 372Accounting Flows versus Cash Flows 372Methods of Ranking InvestmentProposals 375

Payback Method 375Internal Rate of Return 376Net Present Value 378

Selection Strategy 379Reinvestment Assumption 380

Modified Internal Rate of Return 381Capital Rationing 382Net Present Value Profile 383

Characteristics of Investment C 384Combining Cash Flow Analysis andSelection Strategy 386

The Rules of Depreciation 386The Tax Rate 388

Actual Investment Decision 388The Replacement Decision 389

Sale of Old Asset 390Incremental Depreciation 391Cost Savings 392

Elective Expensing 394Summary 394List of Terms 394Discussion Questions 394Practice Problems and Solutions 395Problems 396Comprehensive Problem 405Web Exercise 405S&P Problems 406

13 Risk and Capital Budgeting 407Definition of Risk in CapitalBudgeting 408The Concept of Risk-Averse 409Actual Measurement of Risk 409Risk and the Capital BudgetingProcess 472

Risk-Adjusted Discount Rate 413Increasing Risk over Time 474Qualitative Measures 474

Example—Risk-Adjusted DiscountRate 415

Simulation Models 476Decision Trees 477

The Portfolio Effect 418Portfolio Risk 479Evaluation of Combinations 422

The Share Price Effect 423Summary 423Review of Formulas 423List of Terms 424Discussion Questions 424Practice Problems and Solutions 424Problems 426Comprehensive Problems 436Web Exercise 439

PARTS i LONG-TERM FINANCING

14 Capital Markets 442International Capital Markets 443Competition for Funds in the U.S. CapitalMarkets 445

Government Securities 446U.S. Government Securities 446Federally Sponsored CreditAgencies 446State and Local Securities 446

Corporate Securities 446Corporate Bonds 446Preferred Stock 447Common Stock 447Internal versus External SourcesofFunds 447

The Supply of Capital Funds 448The Role of the Security Markets 450

The Organization of the SecurityMarkets 457

Traditional Organized Exchanges 457Listing Requirements for Firms 452

xxiv Contents

Electronic Communication Networks(ECNs) 452The New York Stock Exchange 453The NASDAQ Market 453Foreign Exchanges 454

Market Efficiency 455The Efficient Market Hypothesis 456

Regulation of the Security Markets 456Securities Act of 1933 456Securities Exchange Act of 1934 457Securities Acts Amendments of 1975 458Sarbanes-OxleyActof2002 458

Summary 460List of Terms 460Discussion Questions 461Web Exercise 461

15 Investment Banking: Public and PrivatePlacement 462

The Role of Investment Banking 463Concentration of Capital 463The Gramm-Leach-Bliley Act Repealsthe Glass-Steagall Act 465Investment Banking Competitors 466

Enumeration of Functions 466Underwriter 466Market Maker 467Advisor 467Agency Functions 467

The Distribution Process 467

The Spread 468Pricing the Security 469

Dilution 470Market Stabilization 477Aftermarket 477Shelf Registration 472

Public versus Private Financing 472Advantages of Being Public 472Disadvantages of Being Public 473

Public Offerings 473A Classic Example of Instant Wealth—EDS Goes Public 473Internet Capital Group—A SecondExample 474

Private Placement 478Going Private and LeveragedBuyouts 478

International Investment Banking Deals 479Privatization 479

Summary 480

List of Terms 480Discussion Questions 481Practice Problems and Solutions 481Problems 482Comprehensive Problem 488Web Exercise 489S&P Problems 489

16 Long-Term Debt and Lease Financing 491

The Expanding Role of Debt 492The Debt Contract 492

Par Value 492Coupon Rate 493Maturity Date 493

Security Provisions 493Unsecured Debt 493Methods of Repayment 494

Serial Payments 494Sinking-Fund Provision 495Conversion 495Call Feature 495

An Example: Kerr McGee's 7.875 PercentBond 495

Bond Prices, Yields, and Ratings 495Bond Yields 498

Coupon Rate (Nominal Yield) 498Current Yield 499Yield to Maturity 499

Bond Ratings 499Examining Actual Bond Ratings 500

The Refunding Decision 507

A Capital Budgeting Problem 507Step A—Outflow Considerations 502Step B—Inflow Considerations 503Step C—Net Present Value 504

Other Forms of Bond Financing 505Advantages and Disadvantages of Debt 506

Benefits of Debt 507Drawbacks of Debt 507Eurobond Market 507

Leasing as a Form of Debt 508

Capital Lease versus Operating Lease 509Income Statement Effect 570Advantages of Leasing 570

Summary 511List of Terms 511Discussion Questions 511Practice Problems and Solutions 512Problems 515Comprehensive Problem 519Web Exercise 520

Contents XXV

S&P Problems 520Appendix 16A Financial Alternatives forDistressed Firms 521

Out-of-Court Settlement 527In-Court Settlements—FormalBankruptcy 522

Reorganization 522Liquidation 522

List of Terms 525Discussion Questions 526Problems 526Appendix 16B Lease versus PurchaseDecision 527Problems 529

17 Common and Preferred Stock Financing 530Common Stockholders' Claim to Income 531The Voting Right 532

Cumulative Voting 533The Right to Purchase New Shares 535

The Use of Rights in Financing 536Rights Required 536Monetary Value of a Right 536

Effect of Rights on Stockholder'sPosition 538

Desirable Features of Rights Offerings 540Poison Pills 540

American Depository Receipts 547Preferred Stock Financing 547

Justification for Preferred Stock 542Investor Interest 542Summary of Tax Considerations 543

Provisions Associated with PreferredStock 543

1. Cumulative Dividends 5432. Conversion Feature 5443. Call Feature 5444. Participation Provision 5445. Floating Rate 5446. Dutch Auction Preferred Stock 5447. Par Value 545

Comparing Features of Common andPreferred Stock and Debt 545Summary 546Review of Formulas 547List of Terms 548Discussion Questions 548Practice Problems and Solutions 549Problems 550Comprehensive Problems 554Web Exercise 556

18 Dividend Policy and Retained Earnings 557The Marginal Principle of RetainedEarnings 558

Life Cycle Growth and Dividends 558Dividends as a Passive Variable 559An Incomplete Theory 559Arguments for the Relevance ofDividends 560

Dividend Stability 567Other Factors Influencing DividendPolicy 567

Legal Rules 567Cash Position of the Firm 563Access to Capital Markets 563Desire for Control 564Tax Position of Shareholders 564

Dividend Payment Procedures 564Stock Dividend 566

Accounting Considerations for a StockDividend 566Value to the Investor 566Possible Value of Stock Dividends 567Use of Stock Dividends 568

Stock Splits 568Reverse Stock Splits 569

Repurchase of Stock as an Alternative toDividends 569

Other Reasons for Repurchase 577Dividend Reinvestment Plans 572Summary 572List of Terms 573Discussion Questions 573Practice Problems and Solutions 573Problems 574Comprehensive Problem 582Web Exercise 582S&P Problems 583

19 Convertibles, Warrants, and Derivatives 584Convertible Securities 585

Value of the Convertible Bond 585Is This Fool's Gold? 588Advantages and Disadvantages to theCorporation 589Forcing Conversion 590Accounting Considerations withConvertibles 597

Financing through Warrants 593Valuation of Warrants 594Use of Warrants in CorporateFinance 596

XXVI Contents

Accounting Considerations withWarrants 597

Derivative Securities 598Options 598Futures 599

Summary 600Review of Formulas 600List of Terms 601Discussion Questions 601Practice Problems and Solutions 602Problems 603Comprehensive Problems 607Web Exercise 608

PART 6 i EXPANDING THE PERSPECTIVE OFCORPORATE FINANCE

20 External Growth through Mergers 612Motives for Business Combinations 613

Financial Motives 613Nonfinancial Motives 675Motives of Selling Stockholders 675

Terms of Exchange 67 7Cash Purchases 677Stock-for-Stock Exchange 618Portfolio Effect 679

Accounting Considerations in Mergers andAcquisitions 620Negotiated versus Tendered Offers 627Premium Offers and Stock PriceMovements 623Two-Step Buyout 624Summary 625List of Terms 625Discussion Questions 625Practice Problems and Solutions 626Problems 627Web Exercise 631S&P Problems 632

21 International Financial Management 633The Multinational Corporation: Nature andEnvironment 636

Exporter 636Licensing Agreement 636Joint Venture 636Fully Owned Foreign Subsidiary 636

Foreign Exchange Rates 637Factors Influencing Exchange Rates 639

Inflation 639Interest Rates 639Balance of Payments 639Government Policies 640Other Factors 640

Spot Rates and Forward Rates 640Cross Rates 642

Managing Foreign Exchange Risk 642Forward Exchange MarketHedge 644Money Market Hedge 644Currency Futures MarketHedge 645

Foreign Investment Decisions 646Analysis of Political Risk 648

Financing International BusinessOperations 649

Funding of Transactions 650Eximbank (Export-Import Bank) 650Loans from the Parent Company or aSister Affiliate 650Eurodollar Loans 652Eurobond Market 653International Equity Markets 653The International FinanceCorporation 655

Some Unsettled Issues in InternationalFinance 656Summary 656List of Terms 657Discussion Questions 658Practice Problems and Solutions 658Problems 659Web Exercise 660S&P Problems 661Appendix 21A Cash Flow Analysis and theForeign Investment Decision 661

Appendixes A-1

Appendix A Future Value of$l, FVIF A-2Appendix B Present Value of$l, PVIF A-4Appendix C Future Value of an Annuity of$1,FVIFA A-6Appendix D Present Value of an Annuity of$1,PVIFA A-8

Glossary G

Indexes 1-1