Foundations of Financial Management

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1 Foundations of Financial Management FOURTEENTH EDITION Stanley B. Block Texas Christian University Geoffrey A. Hirt DePaul University Bartley R. Danielsen North Carolina State University Me Graw Hill McGraw-Hill Irwin

2 Contents PARTI I INTRODUCTION 1 The Goals and Functions of Financial Management 4 List of Terms 21 Discussion Questions Web Exercise The Field of Finance 5 Evolution of the Field of Finance 5 Modern Issues in Finance 6 Risk Management and the Financial Crisis 6 The Impact of the Internet 7 Functions of Financial Management 8 Forms of Organization 8 Sole Proprietorship 9 Partnership 9 Corporation 9 Corporate Governance 11 Sarbanes-Oxley Act 12 Goals of Financial Management 12 A Valuation Approach 13 Maximizing Shareholder Wealth 13 Management and Stockholder Wealth 14 Social Responsibility and Ethical Behavior 14 The Role of the Financial Markets 16 Structure and Functions of the Financial Markets 16 Allocation of Capital 17 Institutional Pressure on Public Companies to Restructure 18 Internationalization of the Financial Markets 18 The Internet and Changes in the Capital Markets 19 Format of the Text 20 Parts Introduction Financial Analysis and Planning Working Capital Management The Capital Budgeting Process Long-Term Financing Expanding the Perspective of Corporate Finance 21 PART 2 I FINANCIAL ANALYSIS AND PLANNING 2 Review of Accounting 26 Income Statement 27 Return to Capital 28 Price-Earnings Ratio Applied to Earnings per Share 28 Limitations of the.income Statement 29 Balance Sheet 30 Interpretation of Balance Sheet Items 30 Concept of Net Worth 32 Limitations of the Balance Sheet 32 Statement of Cash Flows 33 Developing an Actual Statement 34 Determining Cash Flows from Operating Activities 34 Determining Cash Flows from Investing Activities 36 Determining Cash Flows from Financing Activities 36 Combining the Three Sections of the Statement 38 Depreciation and Funds Flow 39 Free Cash Flow 39 Income Tax Considerations 40 Corporate Tax Rates 42 Cost of a Tax-Deductible Expense 42 Depreciation as a Tax Shield 42 Summary 43 List of Terms 44 Discussion Questions 44 Practice Problems and Solutions 44 Problems 46 Web Exercise 54 xvii

3 xviii Contents 3 Financial Analysis 55 Ratio Analysis 56 Classification System 57 The Analysis 55 A. Profitability Ratios 59 B. Asset Utilization Ratios 61 C. Liquidity Ratios 62 D. Debt Utilization Ratios 62 Trend Analysis 63 Impact of Inflation on Financial Analysis 67 An Illustration 67 Disinflation Effect 69 Deflation 69 Other Elements of Distortion in Reported Income 69 Explanation of Discrepancies 70 Sales 70 Cost of Goods Sold 70 Extraordinary Gains/Losses 70 Net Income 72 Summary 72 List of Terms 72 Discussion Questions 73 Practice Problems and Solutions 73 Problems 76 Comprehensive Problems 88 Web Exercise 93 4 Financial Forecasting 94 Constructing Pro Forma Statements 95 Pro Forma Income Statement 95 Establish a Sales Projection 96 Determine a Production Schedule and the Gross Profit 96 Cost of Goods Sold 98 Other Expense Items 99 Actual Pro Forma Income Statement 99 Cash Budget 100 Cash Receipts 700 Cash Payments 101 Actual Budget 102 Pro Forma Balance Sheet 103 Explanation of Pro Forma Balance Sheet 105 Analysis of Pro Forma Statement 106 Percent-of-Sales Method 106 Summary 108 PART 3 I List of Terms 109 Discussion Questions 109 Practice Problems and Solutions 109 Problems 111 Comprehensive Problems 119 Web Exercise Operating and Financial Leverage 122 Leverage in a Business 122 Operating Leverage 123 Break-Even Analysis 123 A More Conservative Approach 125 The Risk Factor 727 Cash Break-Even Analysis 727 Degree of Operating Leverage 128 Leveraged Firm 128 Conservative Firm 129 Limitations of Analysis 729 Financial Leverage 130 Impact on Earnings 131 Degree of Financial Leverage 131 Plan A (Leveraged) 133 Plan B (Conservative) Limitations to Use of Financial Leverage 134 Combining Operating and Financial Leverage 134 Degree of Combined Leverage 136 A Word of Caution 138 Summary 138 Review of Formulas 138 List of Terms 139 Discussion Questions 139 Practice Problems and Solutions 140 Problems 141 Comprehensive Problem 150 Web Exercise 152 WORKING CAPITAL MANAGEMENT 6 Working Capital and the Financing Decision 156 The Nature of Asset Growth 757 Controlling Assets Matching Sales and Production 158 Temporary Assets under Level Production An Example 162

4 Contents XIX Patterns of Financing 767 Alternative Plans 168 Long-Term Financing 168 Short-Term Financing (Opposite Approach) 169 The Financing Decision 169 Term Structure of Interest Rates 7 77 A Decision Process 174 Introducing Varying Conditions 776 Expected Value 7 76 Shifts in Asset Structure 1-77 Toward an Optimal Policy 7 77 Summary 179 List of Terms 180 Discussion Questions 180 Practice Problems and Solutions 181 Problems 182 Web Exercise Current Asset Management 190 Cash Management 797 Reasons for Holding Cash Balances 797 Cash Flow Cycle 797 Collections and Disbursements 193 Float 795 Improving Collections 795 Extending Disbursements 795 Cost-Benefit Analysis. 796 Electronic Funds Transfer 796 International Cash Management 198 Marketable Securities 799 Management of Accounts Receivable 202 Accounts Receivable as an Investment 203 Credit Policy Administration 203 Credit Standards 203 Terms of Trade 205 Collection Policy 207 An Actual Credit Decision 208 Inventory Management 209 Level versus Seasonal Production 209 Inventory Policy in Inflation (and Deflation) 270 The Inventory Decision Model 270 Carrying Costs 210 Ordering Costs 210 Economic Ordering Quantity 270 Safety Stock and Stockouts 272 Just-in-Time Inventory Management 213 Cost Savings from Lower Inventory 213 Other Benefits 214 The Downside of JIT 214 Summary 215 List of Terms 216 Discussion Questions 217 Practice Problems and Solutions 217 Problems 218 Comprehensive Problem 223 Web Exercise Sources of Short-Term Financing 225 Trade Credit 226 Payment Period 226 Cash Discount Policy 226 Net Credit Position 227 Bank Credit 227 Prime Rate and LIBOR 228 Compensating Balances 228 Maturity Provisions 230 Cost of Commercial Bank Financing 230 Interest Costs with Compensating Balances 257 Rate on Installment Loans 232 Annual Percentage Rate 232 The Credit Crunch Phenomenon 233 Financing through Commercial Paper 234 Advantages of Commercial Paper 235 Limitations on the Issuance of Commercial Paper 235 Foreign Borrowing 236 Use of Collateral in Short-Term Financing 237 Accounts Receivable Financing 237 Pledging Accounts Receivable 238 Factoring Receivables 238 Asset-Backed Public Offerings 239 Inventory Financing 240 Stages of Production 240 Nature of Lender Control 240 Blanket Inventory Liens 240 Trust Receipts 240 Warehousing 240 Appraisal of Inventory Control Devices 241 Hedging to Reduce Borrowing Risk 242 Summary 243 List of Terms 244

5 XX Contents PART 4 I Discussion Questions 244 Practice Problems and Solutions Problems 246 Web Exercise THE CAPITAL BUDGETING PROCESS 9 The Time Value of Money 255 Relationship to the Capital Outlay Decision 256 Future Value Single Amount 256 Present Value Single Amount 257 Future Value Annuity 258 Present Value Annuity 260 Graphical Presentation of Time Value Relationships 262 The Relationship between Present Value and Future Value 262 The Relationship between the Present Value of a Single Amount and the Present Value of an Annuity 265 Future Value Related to the Future Value of an Annuity 267 Determining the Annuity Value 268 Annuity Equaling a Future Value 268 Annuity Equaling a Present Value 268 Determining the Yield on an Investment 270 Yield Present Value of a Single Amount 270 Yield Present Value of an Annuity 2 77 Special Considerations in Time Value Analysis 272 Patterns of Payment 272 Special Review of the Chapter 274 List of Terms 276 Discussion Questions 276 Practice Problems and Solutions 277 Problems 278 Comprehensive Problem Valuation and Rates of Return 285 Valuation Concepts 286 Valuation of Bonds 286 Present Value of Interest Payments 287 Present Value of Principal Payment (Par Value) at Maturity 287 Concept of Yield to Maturity 288 Changing the Yield to Maturity and the Impact on Bond Valuation 290 Increase in Inflation Premium 290 Decrease in Inflation Premium 290 Time to Maturity 292 Determining Yield to Maturity from the Bond Price 292 A 13 Percent Discount Rate 293 A 12 Percent Discount Rate 294 Formula for Bond Yield 294 Semiannual Interest and Bond Prices 295 Valuation and Preferred Stock 296 Determining the Required Rate of Return (Yield) from the Market Price 298 Valuation of Common Stock 29S No Growth in Dividends 299 Constant Growth in Dividends 299 Stock Valuation Based on Future Stock Value 301 Determining the Required Rate of Return from the Market Price 307 ' The Price-Earnings Ratio Concept and Valuation 302 Variable Growth in Dividends 305 Summary and Review of Formulas 306 Bonds 306 Preferred Stock 307 Common Stock 307 List of Terms 308 Discussion Questions 308 Practice Problems and Solutions 309 Problems 310 Comprehensive Problem 316 Web Exercise 317 Appendix 10A The Bond Yield to Maturity Using Interpolation 318 Appendix 10B Using Calculators for Financial Analysis 319 Appendix IOC Valuation of a Supernormal Growth Firm Cost of Capital 331 The Overall Concept 331 Cost of Debt 332 Costs of Preferred Stock 335 Cost of Common Equity 335 Valuation Approach 336 Required Return on Common Stock Using the Capital Asset Pricing Model 336

6 Contents xxi Cost of Retained Earnings 337 Cost of New Common Stock 339 Overview of Common Stock Costs 339 Optimal Capital Structure Weighting Costs ' 340 Capital Acquisition and Investment Decision Making 342 Cost of Capital in the Capital Budgeting Decision 342 The Marginal Cost of Capital 344 Summary 349 Review of Formulas 350 List of Terms 350 Discussion Questions 351 Practice Problems and Solutions 351 Problems 354 Comprehensive Problems 362 Web Exercise 364 Appendix 11A Cost of Capital and the Capital Asset Pricing Model (Optional) The Capital Budgeting Decision 372 Administrative Considerations 373 Accounting Flows versus Cash Flows 374 Methods of Ranking Investment Proposals 375 Payback Method 375 Internal Rate of Return 376 Net Present Value 379 Selection Strategy 380 Reinvestment Assumption 380 Modified Internal Rate of Return 381 Capital Rationing 383 Net Present Value Profile 383 Characteristics of Investment C 384 Combining Cash Flow Analysis and Selection Strategy 386 The Rules of Depreciation 386 The Tax Rate 389 Actual Investment Decision 390 The Replacement Decision 391 Sale of Old Asset 392 Incremental Depreciation 393 Cost Savings 394 Elective Expensing 395 Summary 396 List of Terms 396 Discussion Questions 396 Practice Problems and Solutions 397 PART 5 I Problems 398 Comprehensive Problem Web Exercise Risk and Capital Budgeting 409 Definition of Risk in Capital Budgeting 409 The Concept of Risk-Averse 477 Actual Measurement of Risk 411 Risk and the Capital Budgeting Process 414 Risk-Adjusted Discount Rate 415 Increasing Risk over Time 476 Qualitative Measures 476 Example Risk-Adjusted Discount Rate 417 Simulation Models 418 Decision Trees 418 The Portfolio Effect 420 Portfolio Risk 427 Evaluation of Combinations 424 The Share Price Effect 425 Summary 425 Review of Formulas 425 List of Terms 426 Discussion Questions 426 Practice Problems and Solutions 426 Problems 428 Comprehensive Problems 439 Web Exercise 441 LONG-TERM FINANCING 14 Capital Markets 444 International Capital Markets 445 Competition for Funds in the U.S. Capital Markets 447 Government Securities 448 U.S. Government Securities 448 Federally Sponsored Credit Agencies 448 State and Local Securities 448 Corporate Securities 448 Corporate Bonds 448 Preferred Stock 449 Common Stock 449 Internal versus External Sources of Funds 449

7 XX11 Contents The Supply of Capital Funds 450 The Role of the Security Markets 453 The Organization of the Security Markets 453 Traditional Organized Exchanges 454 Listing Requirements for Firms 454 Electronic Communication Networks (ECNs) 454 The New York Stock Exchange 455 The NASDAQ Market 456 Foreign Exchanges 457 -, Other Financial Exchanges 457 Market Efficiency 458 The Efficient Market Hypothesis 458 Regulation of the Security Markets 459 Securities Act of Securities Exchange Act of Securities Acts Amendments of Sarbanes-Oxley Act of Summary 462 List of Terms 463 Discussion Questions 463 Web Exercise Investment Banking: Public and Private Placement 465 The Role of Investment Banking 466 Concentration of Capital 466 The Gramm-Leach-Bliley Act Repeals the Glass-Steagall Act 468 Investment Banking Competitors 469 Enumeration of Functions 469 Underwriter 469 Market Maker 470 Advisor 470 Agency Functions 470 The Distribution Process 470 The Spread 471 Pricing the Security 472 Dilution 474 Market Stabilization 474 Aftermarket 474 Shelf Registration 475 Public versus Private Financing 475 Advantages of Being Public 475 Disadvantages of Being Public 476 Public Offerings 477 A Classic Example Rosetta Stone Goes Public 477 Private Placement 479 Going Private and Leveraged Buyouts 479 International Investment Banking Deals 481 Privatization 457 Summary 482 List of Terms 483 Discussion Questions 483 Practice Problems and Solutions 483 Problems 485 Comprehensive Problem 490 Web Exercise Long-Term Debt and Lease Financing 493 The Expanding Role of Debt 493 The Debt Contract 494 Par Value 494 Coupon Rate 494 Maturity Date 494 Security Provisions 495 Unsecured Debt 495 Methods of Repayment 496 Serial Payments 497 Sinking-Fund Provision 497 Conversion 497 Call Feature 497 An Example: Eli Lilly's 6.77 Percent Bond 497 Bond Prices, Yields, and Ratings 497 Bond Yields 500 Coupon Rate (Nominal Yield) 500 Current Yield 501 Yield to Maturity 501 Bond Ratings 507 Examining Actual Bond Ratings 502 The Refunding Decision 502 A Capital Budgeting Problem 503 Step A Outflow Considerations 504 Step B Inflow Considerations 505 Step C Net Present Value 506 Other Forms of Bond Financing 507 Advantages and Disadvantages of Debt 508 Benefits of Debt 509 Drawbacks of Debt 509 Eurobond Market 509 Leasing as a Form of Debt 570 Capital Lease versus Operating Lease 57/

8 Contents xxm Income Statement Effect 572 Advantages of Leasing 572 Summary 513 List of Terms 513 Discussion Questions 514 Practice Problems and Solutions 515 Problems 517 Comprehensive Problem 522 Web Exercise 522 Appendix 16A Financial Alternatives for Distressed Firms 523 < Out-of-Court Settlement 523 In-Court Settlements Formal Bankruptcy 524 Reorganization 524 Liquidation 524 List of Terms 527 Discussion Questions 528 Problems 528 Appendix 16B Lease versus Purchase Decision 529 Problem 531 r 17 Common and Preferred Stock Financing 533 Common Stockholders' Claim to Income 534 The Voting Right 536 Cumulative Voting 536 The Right to Purchase New Shares 539 The Use of Rights in Financing 539 Rights Required 540 Monetary Value of a Right 541 Effect of Rights on Stockholder's Position 542 Desirable Features of Rights Offerings 543 Poison Pills 545 American Depository Receipts 545 Preferred Stock Financing 546 Justification for Preferred Stock 546 Investor Interest 547 Summary of Tax Considerations 547 Provisions Associated with Preferred Stock Cumulative Dividends Conversion Feature Call Feature Participation Provision Floating Rate Auction Rate Preferred Stock Par Value 549 Comparing Features of Common and Preferred Stock and Debt 550 Summary 551 Review of Formulas 552 List of Terms 553 Discussion Questions 553 Practice Problems and Solutions 554 Problems 555 Comprehensive Problems 560 Web Exercise Dividend Policy and Retained Earnings 563 The Marginal Principle of Retained Earnings 564 Life Cycle Growth and Dividends 564 Dividends as a Passive Variable 565 An Incomplete Theory 566 Arguments for the Relevance of Dividends 566 Dividend Stability 567 Other Factors Influencing Dividend Policy 569 Legal Rules 569 Cash Position of the Firm 570 Access to Capital Markets 570 Desire for Control 570 Tax Position of Shareholders 570 Dividend Payment Procedures 577 Stock Dividend 572 Accounting Considerations for a Stock Dividend 572 Value to the Investor 573 Possible Value of Stock Dividends 574 Use of Stock Dividends 574 Stock Splits 575 Reverse Stock Splits 575 Repurchase of Stock as an Alternative to Dividends 576 Other Reasons for Repurchase 577 Dividend Reinvestment Plans 579 Summary 579 List of Terms 580 Discussion Questions 580 Practice Problems and Solutions 581 Problems 582

9 XXIV Contents PART 6 I Comprehensive Problem 589 Web Exercise Convertibles, Warrants, and Derivatives 591 Convertible Securities 592 Value of the Convertible Bond 592 Is This Fool's Gold? 595 Advantages and Disadvantages to the Corporation 596 Forcing Conversion 597 Accounting Considerations with Convertibles 598 Financing through Warrants 600 Valuation of Warrants 607 Use of Warrants in Corporate Finance 604 Accounting Considerations with Warrants 604 Derivative Securities 605 Options 605 Futures 606 Summary 607 k Review of Formulas 607 List of Terms 608 Discussion Questions 608 Practice Problems and Solutions 609 Problems 610 Comprehensive Problems 615 Web Exercise 616 EXPANDING THE PERSPECTIVE OF CORPORATE FINANCE 20 External Growth through Mergers 620 Motives for Business Combinations 627 Financial Motives 627 Nonfinancial Motives 623 Motives of Selling Stockholders 623 Terms of Exchange 625 Cash Purchases 625 Stock-for-Stock Exchange 626 Portfolio Effect 627 Accounting Considerations in Mergers and Acquisitions 62S Negotiated versus Tendered Offers 629 Premium Offers and Stock Price Movements 631 Two-Step Buyout 632 Summary 633 List of Terms 633 Discussion Questions 634 Practice Problems and Solutions 634 Problems 636 Web Exercise International Financial Management 641 The Multinational Corporation: Nature and Environment 644 Exporter 644 Licensing Agreement 644 Joint Venture 644 Fully Owned Foreign Subsidiary 644 Foreign Exchange Rates 645 Factors Influencing Exchange Rates 647 Inflation 647 Interest Rates 647 Balance of Payments 647. Government Policies 648 Other Factors 648 Spot Rates and Forward Rates 648 Cross Rates 650 Managing Foreign Exchange Risk 650 Forward Exchange Market Hedge 653 Money Market Hedge 653 Currency Futures Market Hedge 653 Foreign Investment Decisions 654 Analysis of Political Risk 656 Financing International Business Operations 658 Funding of Transactions 658 Eximbank (Export-Import Bank) 658 Loans from the Parent Company or a Sister Affiliate 658 Eurodollar Loans 660 Eurobond Market 661 International Equity Markets 661 The International Finance Corporation 663 Some Unsettled Issues in International Finance 664 Summary 664 List of Terms 665 Discussion Questions 666 Practice Problems and Solutions 666

10 Contents XXV Problems 667 Web Exercise 668 Appendix 21A Cash Flow Analysis and the Foreign Investment Decision 669 Appendix C Future Value of an Annuity of $1, FV IFA A-6 Appendix D Present Value of an Annuity of $1, PV IFA A-8 Appendixes A-1 Appendix A Future Value of$l, FV w Appendix B Present Value of $1, PV IF A-2 A-4 Glossary Indexes G 1-1

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