raymond m. brooks - willkommen concepts and basic tools of finance 1 ... 1.9 corporate governance...

RAYMOND M. BROOKSOregon State University

Boston Columbus Indianapolis New York San Francisco Upper Saddle RiverAmsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto

Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

PART I

Fundamental Concepts and BasicTools of Finance 1

1 Financial Management1.1 The Cycle of Money 41.2 Overview of Finance Areas 51.3 Financial Markets 6

1.4 The Finance Manager and FinancialManagement 7

1.5 Objective of the Finance Manager 9Profit Maximization 9Maximizing Current Stock Price 9

1.6 Internal and External Players 101.7 The Legal Forms of Business 12

Proprietorship 12Partnership 12Corporations 13Hybrid Corporations 14Not-for-Profit Corporations 14

1.8 The Financial Management Setting:The Agency Model 14

1.9 Corporate Governance and BusinessEthics 18

FINANCE FOLLIES The Financial Meltdown

of 2008 191.10 Why Study Finance? 20

PUTTING FINANCE TO WORK "NowHiring" 21

Key Terms 22Questions 22Prepping for Exams 23MINI-CASE Richards' Tree Farm

Grows Up 25• Summary Card at end of text

L Financial Statements 272.1 Financial Statements 28

The Balance Sheet 28

The Income Statement 31Statement of Retained Earnings 33

2.2 Cash Flow Identity 34

The First Component: Cash Flow from Assets 35The Second Component: Cash Flow

to Creditors 36The Third Component: Cash Flow

to Owners 36Putting It All Together: The Cash

Flow Identity 362.3 Financial Performance Reporting 37

Regulation Fair Disclosure 37Notes to the Financial Statements 37

2.4 Financial Statements on the Internet 38PUTTING FINANCE TO WORK Look Before

You Leap 41

Key Terms 42Questions 42Prepping for Exams 42Problems 44MINI-CASE Hudson Valley Realty 48

• Summary Card at end of text

The Time Value of Money (Part 1) 513.1 Future Value and the Compounding

of Interest 52The Single-Period Scenario 52The Multiple-Period Scenario 52Methods of Solving Future Value Problems 53

3.2 Present Value and Discounting 57The Single-Period Scenario 57The Multiple-Period Scenario 58The Use of Time Lines 60

3.3 One Equation and Four Variables 603.4 Applications of the Time Value of Money

Equation 62

PUTTING FINANCE TO WORK Sports Agent 67

3.5 Doubling of Money: The Rule of 72 68

Key Terms 69Questions 69

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A very good job in making the concept of financofTVM early in the text. The author Jidso

The explanation of bond pricingand yieldcdlciilc f^' -iv rji •

Prepping for Exams 70Problems 72MINI-CASE Richards' Tree Farm, Inc.:

The Continuing Saga 77


4 The Time Value of Money (Part 2) 794.1 Future Value of Multiple Payment

Streams 804.2 Future Value of an Annuity Stream 81

Future Value of an Annuity:An Application 83

4.3 Present Value of an Annuity 85

PUTTING FINANCE TO WORK Modeling theFuture with Actuarial Science 87

4.4 Annuity Due and Perpetuity 88Perpetuity 90

4.5 Three Payment Methods 90Interest and Principal at the Maturity of Loan

(Discount Loan) 91Interest As You Go, Principal at Maturity of Loan

(Interest-Only Loan) 91Interest and Principal As You Go (Amortized

Loan) 914.6 Amortization Schedules 934.7 Waiting Time and Interest Rates

for Annuities 944.8 Solving a Lottery Problem 964.9 Ten Important Points about the TVM

Equation 99

Key Terms 100Questions 100Prepping for Exams 101Problems 102

MINI-CASE Fitchminster Injection Molding, Inc.:Rose Climbs High 109


5 Interest Rates i l l

5.1 How Interest Rates Are Quoted: Annual andPeriodic Interest Rates 112

5.2 Effect of Compounding Periods on the TimeValue of Money Equations 114

5.3 Consumer Loans and AmortizationSchedules 118

5.4 Nominal and Real Interest Rates 1225.5 Risk-Free Rate and Premiums 124

Maturity Premiums 1265.6 A Brief History of Interest Rates and Inflation

in the United States 128

Key Terms 130Questions 130Prepping for Exams 131Problems 133MINI-CASE Sweetening the Deal: Lott Brothers

Developers 137• Summary Card at end of text

PART IIValuing Stocks and Bonds andUnderstanding Risk and Return 139

O Bonds and Bond Valuation 1416.1 Application of the Time Value of Money Tool:

Bond Pricing 142Key Components of a Bond 142Pricing a Bond in Steps 143

6.2 Semiannual Bonds and Zero-CouponBonds 146Pricing Bonds after Original Issue 148Zero-Coupon Bonds 150Amortization of a Zero-Coupon Bond 151

6.3 Yields and Coupon Rates 153The First Interest Rate: Yield to Maturity 153The "Other" Interest Rate: Coupon Rate 155Relationship of Yield to Maturity and

Coupon Rate 1556.4 Bond Ratings 1566.5 Some Bond History and More Bond

Features 1606.6 U.S. Government Bonds 163

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PUTTING FINANCE TO WORK MunicipalManager 164

Pricing a U.S. Government Note or Bond 165Pricing a Treasury Bill 165


MINI-CASE Bay Path Cranberry Products 173• Summary Card at end of text

/ Stocks and Stock Valuation 1757.1 Characteristics of Common Stock 176

Ownership 176Claim on Assets and Cash Flow

(Residual Claim) 176Vote (Voice in Management) 176No Maturity Date 177Dividends and Their Tax Effect 177Authorized, Issued, and Outstanding Shares 177Treasury Stock 178Preemptive Rights 178

7.2 Stock Markets 178Primary Markets 178Secondary Markets: How Stocks Trade 180Bull Markets and Bear Markets 180

7.3 Stock Valuation 181The Constant Dividend Model with an Infinite

Horizon 183

The Constant Dividend Model with a FiniteHorizon 184

The Constant Growth Dividend Model with anInfinite Horizon 186

The Constant Growth Dividend Model with aFinite Horizon 188

Nonconstant Growth Dividends 190

FINANCE FOLLIES Irrational Expectations: Bulbsand Bubbles 191

7.4 Dividend Model Shortcomings 1927.5 Preferred Stock 1957.6 Efficient Markets 196

Operational Efficiency 196Informational Efficiency 196

Key Terms 198Questions 198Prepping for Exams 198Problems 200MINI-CASE Lawrence's Legacy: Part 1 204• Summary Card at end of text

O Risk and Return 207

8.1 Returns 208

Dollar Profits and Percentage Returns 208Converting Holding Period Returns to Annual

Returns 209Extrapolating Holding Period Returns 211

8.2 Risk (Certainty and Uncertainty) 211

FINANCE FOLLIES "Dangerous to Your Wealth":Is Investingjust Gambling? 212

8.3 Historical Returns 2138.4 Variance and Standard Deviation as a Measure

of Risk 217Normal Distributions 219

8.5 Returns in an Uncertain World (Expectationsand Probabilities) 221FINANCE FOLLIES "Scam of the Century": Bernie

Madoff and the $50 Billion Fraud 222Determining the Probabilities of All Potential

Outcomes 223

8.6 The Risk-and-Return Trade-off 225Investment Rules 226

8.7 Diversification: Minimizing Risk orUncertainty 227When Diversification Works 229Adding More Stocks to the Portfolio: Systematic

and Unsystematic Risk 231

8.8 Beta: The Measure of Risk in a Well-DiversifiedPortfolio 232

8.9 The Capital Asset Pricing Model and theSecurity Market Line 233

The Capital Asset Pricing Model (CAPM) 234Application of the SML 236

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Vv

Capital budgeting: * * Just exactly what I like to cover in On int

Cash flow estimation: Logical, easy to read; atid a

Key Terms 238Questions 238Prepping for Exams 239Problems 241MINI-CASE Lawrence's Legacy: Part 2 247


PART IIICapital Budgeting 249

y Capital Budgeting DecisionModels 251

9.1 Short-Term and Long-Term Decisions 252FINANCE FOLLIES IBM Exits the Consumer

Software Market: Misreading Future

Cash Flows 253

9.2 Payback Period 254Discounted Payback Period 256

9.3 Net Present Value 257Mutually Exclusive versus Independent

Projects 259Unequal Lives of Projects 261Net Present Value Example: Equation and

Calculator Function 2639.4 Internal Rate of Return 264

Appropriate Discount Rate or Hurdle Rate 266Problems with the Internal Rate of Return 267PUTTING FINANCE TO WORK Marketing and

Sales: Your Product = Your Customer's Capital

Budgeting Decision 268Multiple Internal Rates of Return 269Reinvestment Rate 270Modified Internal Rate of Return 273

9.5 Profitability Index 2759.6 Overview of Six Decision Models 276

Capital Budgeting Using a Spreadsheet 278


MINI-CASE BioCom, Inc. 288


1 0 Cash Flow Estimation 29110.1 The Importance of Cash Flow 29210.2 Estimating Cash Flow for Projects:

Incremental Cash Flow 293Sunk Costs 294Opportunity Costs 294Erosion Costs 295Synergy Gains 297Working Capital 297FINANCE FOLLIES Boston's "Big Dig" Gets Dug

Under 299

10.3 Capital Spending and Depreciation 300Modified Accelerated Cost Recovery System 301

10.4 Cash Flow and the Disposal of CapitalEquipment 304

10.5 Projected Cash Flow for a NewProduct 305

Key Terms 310Questions 310Prepping for Exams 310Problems 312MINI-CASE Charbridge Office Furniture: Part 1,

A New Product Line? 316


1 1 The Cost of Capital 319

11.1 The Cost of Capital: A Starting Point 32011.2 Components of the Weighted Average Cost

of Capital 322Debt Component 323Preferred Stock Component 324Equity Component 325Retained Earnings 327

11.3 Weighting the Components: Book Valueor Market Value? 328Book Value 328Adjusted Weighted Average Cost of Capital 330Market Value 330

XXIU

Cathy Goldberg, University of San Francisco

11.4 Using the Weighted Average Cost of Capitalin a Budgeting Decision 331Individual Weighted Average Cost of Capital

for Individual Projects 33211.5 Selecting Appropriate Betas for Projects 33511.6 Constraints on Borrowing and Selecting

Projects for the Portfolio 336

339

Key Terms 338Questions 338Prepping for ExamsProblems 341

MINI-CASE Charbridge Office Furniture: Part 2,

A Fresh Look at the WACC 347• Summary Card at end of text

PART IVFinancial Planning and EvaluatingPerformance 349

1 L Forecasting and Short-Term FinancialPlanning 351

12.1 Sources and Uses of Cash 35212.2 Cash Budgeting and the Sales Forecast 354

Cash Inflow from Sales 356Other Cash Receipts 357

12.3 Cash Outflow from Production 35812.4 The Cash Forecast: Short-Term Deficits

and Short-Term Surpluses 359Funding Cash Deficits 360Investing Cash Surpluses 362

12.5 Planning with Pro Forma FinancialStatements 362Pro Forma Income Statement 363Pro Forma Balance Sheet 365PUTTING FINANCE TO WORK Information

Technology 368

Key Terms 369Questions 369Prepping for Exams 369

^^-^^^^P11"*5 receivable managementWarren Palmer, Beloit College

Problems 371

MINI-CASE Midwest Properties:Quarterly Forecasting 375


LD Working Capital Management 37913.1 The Cash Conversion Cycle 380

Average Production Cycle 382Average Collection Cycle 383Average Payment Cycle 384Putting It All Together: The Cash

Conversion Cycle 38413.2 Managing Accounts Receivable and Setting

Credit Policy 385

Collecting Accounts Receivable 385Credit: A Two-Sided Coin 386Qualifying for Credit 387Setting Payment Policy 389Collecting Overdue Debt 391

13.3 The Float 392

Speeding Up the Collection (Shortening theLag Time) 394

Slowing Down Payment (Lengthening theLag Time) 395

13.4 Inventory Management: Carrying Costsand Ordering Costs 395

ABC Inventory Management 396Redundant Inventory Items 396Economic Order Quantity 397

13.5 The Effect of Working Capital on CapitalBudgeting 402PUTTING FINANCE TO WORK Operations

Management 403Inventories and Daily Operations 403


MINI-CASE Cranston Dispensers Inc.:Parti 412


XXIV

1 4 Financial Ratios and FirmPerformance 415

14.1 Financial Statements 416

Benchmarking 417

14.2 Financial Ratios 420

Short- Term Solvency: Liquidity Ratios 421

Long-Term Solvency: Solvency or Financial

Leverage Ratios 423

Asset Management Ratios 424

Profitability Ratios 426

Market Value Ratios 427

DuPont Analysis 42914.3 External Uses of Financial Statements

and Industry Averages 430

Cola Wars 431

Industry Ratios 432

FINANCE FOLLIES Cooking the Books at Enronand WorldCom 434

Key Terms 435 /

Questions 435

Prepping for Exams 435

Problems 437

MINI-CASE Cranston Dispensers Inc.: Part 2,

Financial Statement Analysis 443


PART V

Other Selected Finance Topics 447

1 5 Raising Capital 44915.1 The Business Life Cycle 450

15.2 Borrowing for a Start-up and GrowingBusiness 450

Personal Funds and Family Loans 450

Commercial Bank Loans 451

Commercial Banking Loans through the Small

Business Administration 451

Angel Financing and Venture Capital 452

15.3 Borrowing for a Stable and Mature Business:Bank Loans 456

Straight Loans 456

Discount Loans 457

Letter of Credit or Line of Credit 458

Compensating Balance 458

15.4 Borrowing for a Stable and Mature Business:Selling Bonds 459

15.5 Borrowing for a Stable and Mature Business:Selling Stock 461

Initial Public Offerings and Underwriting 461

Registration, Prospectus, and Tombstone 463

The Marketing Process: Road Show 464

The Auction 465

The Aftermarket: Dealer in the Shares 466PUTTING FINANCE TO WORK Corporate

Law 468

15.6 Other Borrowing Options for a MatureBusiness 468

15.7 The Final Phase: Closing the Business 471

Straight Liquidation: Chapter 7 471

Reorganization: Chapter 11 472

Key Terms 473

Questions 473

Prepping for Exams 473

Problems 475

MINI-CASE AKWebDevelopers.com 478


I D Capital Structure 48116.1 Capital Markets: A Quick Review 48216.2 Benefits of Debt 484

Earnings per Share as a Measure of the Benefitsof Borrowing 484

16.3 Break-Even Earnings for Different CapitalStructures 486

16.4 Pecking Order 489

Firms Prefer Internal Financing First 489Firms Choose to Issue Cheapest Security First

and Use Equity as a Last Resort 489

XXV

Eric Hayden, University of Massachusetts, Boston

16.5 Modigliani and Miller on Optimal CapitalStructure 491

Capital Structure in a World of No Taxes and NoBankruptcy 492

Capital Structure in a World of Corporate Taxesand No Bankruptcy 495

Debt and the Tax Shield 49616.6 The Static Theory of Capital Structure 499

Bankruptcy 499Static Theory of Capital Structure 500FINANCE FOLLIES Long-Term Capital

Management: The Really Smart Guys Get intoBig Trouble 501


MINI-CASE General Energy Storage Systems:

How Much Debt and How Much Equity? 508• Summary Card at end of text

1 / Dividends, Dividend Policy,and Stock Splits 511

17.1 Cash Dividends 512Buying and Selling Stock 512Declaring and Paying a Cash Dividend:

A Chronology 512Different Types of Dividends 514'

17.2 Dividend Policy 516Dividend Clienteles 516Dividend Policy Irrelevance 517Reasons Favoring a Low- or No-Dividend-Payout

Policy 520

Reasons Favoring a High-Dividend-PayoutPolicy 521

Optimal Dividend Policy 52217.3 Selecting a Dividend Policy 522

Some Further Considerations in the Selectionof a Dividend Policy 524

17.4 Stock Dividends, Stock Splits, and ReverseSplits 525

Reasons for Stock Splits 526Reverse Splits 527

17.5 Specialized Dividend Plans 527Stock Repurchase 528Dividend Reinvestment Plans 530


MINI-CASE East Coast Warehouse Club 537


1 0 International FinancialManagement 541

18.1 Managing Multinational Operations 542Cultural Risk 542Business Risk 544Political Risk 545

FINANCE FOLLIES Daimler-Chrysler: A MarriageMade in Heaven? 546

18.2 Foreign Exchange 547Purchasing Power Parity 547Currency Exchange Rates 549Cross Rates 550Arbitrage Opportunities 552Forward Rates 553

Using Forward Rates 55518.3 Transaction, Operating, and Translation

Exposures 557Transaction Exposure 557Operating Exposure 558Translation Exposure 559

18.4 Foreign Investment Decisions 559


MINI-CASE Scholastic Travel ServicesInc. 568


XXVI

Appendix 1 Future Value Interest Factors 570Appendix 2 Present Value Interest Factors 572Appendix 3 Future Value Interest Factors of an

Annuity 574Appendix 4 Present Value Interest Factors of an

Annuity 576

Appendix 5 Answers to Prepping for ExamQuestions 579

Glossary 589Index 599Credits 609

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raymond m. brooks - willkommen concepts and basic tools of finance 1 ... 1.9 corporate governance...

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