An Introduction to Institutions, Management, & Investments TEMTH EBITIQM HERBERT B. MAYO The College of New Jersey *\ SOUTH-WESTERN t% CENGAGE Learning- Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United States
D H IF (Q)RO 7 I i IT Preface xxii H An Introduction to Basic Finance 1 PART 1 FINANCIAL INSTITUTIONS 12 2 The Role of Financial Markets and Financial Intermediaries 14 3 Investment Banking 36 4 Securities Markets 48 5 The Federal Reserve 65 (5 International Currency Flows 87 PART 2 FINANCIAL TOOLS 102 1 The Time Value of Money 104 8 Risk and Its Measurement 137 9 Analysis of Financial Statements 168 PART 3 CORPORATE FINANCE 218 11 Forms of Business and Corporate Taxation 220 1H Break-Even Analysis and the Payback Period 230 12 Leverage 242 13 Cost of Capital 260 14 Capital Budgeting 288 15 Forecasting 332 1(5 Cash Budgeting 365 iv
Brief Contents [ -s_ 17 Management of Current Assets 379 1E Management of Short-Term Liabilities 418 19 Intermediate-Term Debt and Leasing 442 PART 4 INVESTMENTS 458 20 The Features of Stock 460 21 Stock Valuation 486 22 The Features of Long-Term Debt Bonds 505 23 Bond Pricing and Yields 521 24 Preferred Stock 537 25 Convertible Securities 548 26 Investment Returns 567 2? Investment Companies 576 PART 5 DERIVATIVES 600 2 Options: Puts and Calls 602 29 Futures and Swaps 624 A Interest Factors for the Future Value of One Dollar 645 i Interest Factors for the Present Value of One Dollar 647 Interest Factors for the Future Value of an Annuity of One Dollar 649 Interest Factors for the Present Value of an Annuity of One Dollar 651 E Using Excel to Solve Financial Problems 653 Answers to Selected Problems 676 Index 685
C IT1I? Preface xxii An Introduction to Basic Finance 1 The Divisions of Finance 2 Key Financial Concepts 3 Sources of Finance 3 Risk and Return 4 Financial Leverage 5 Valuation 6 Finance and Other Business Disciplines 7 Plan of the Text 8 Relationships 10 PART 1 FINANQAL INSTITUTIONS 12 Clfoapteir2 The Role of Financial Markets and Financial Intermediaries 14 The Role of Money 15 Measures of the Supply of Money 16 The Role of Interest Rates 17 The Term Structure of Interest Rates 17 Financial Markets and the Transfer of Savings 19 The Indirect Transfer Through Financial Intermediaries 20 Commercial Banks 21 Thrift Institutions 23 Regulation of Commercial Banks and Thrift Institutions 24 Reserves 24 Deposit Insurance 26 Life Insurance Companies 27 t> vi»
Contents j v--[_ Pension Plans 28 Money Market Mutual Funds and Money Market Instruments 29 Competition for Funds 32 Summary 33 Review Objectives 34 Relationships 34 Answers 35 Investment Banking 36 The Transfer of Funds to Business 37 The Role of Investment Bankers 37 Pricing a New Issue 39 Marketing New Securities 40 Volatility of the Market for Initial Public Offerings 41 Shelf Registrations 42 The Regulation of New Public Issues of Corporate Securities 43 Sarbanes-Oxley Act of 2002 45 Summary 46 Review Objectives 47 Internet Assignment 47 Securities Markets 48 Market Makers 49 Composite Transactions 51 The Mechanics of Investing in Securities 52 Delivery of Securities 54 The Short Sale 55 Measures of Securities Prices 55 Foreign Securities 57 Competition in the Securities Markets 58 Summary 60 Review Objectives 61 Internet Assignment 61 Problems 61 Additional Problems with Answers 63
Contents Internet Assignments 162 Problems 162 Additional Problems with Answers 164 Answers 165 Relationships 166 Answers 167 :eir 9 Analysis of Financial Statements 168 General Accounting Principles 169 The Balance Sheet 170 The Income Statement 176 Statement of Cash Flows 178 Limitations of Accounting Data 181 Depreciation 183 Accelerated Depreciation 185 Methods of Depreciation Compared 187 Ratio Analysis of Financial Statements 189 Liquidity Ratios 191 The Current Ratio 191 The Quick Ratio 192 The Components of the Current Assets 193 Activity Ratios 194 Inventory Turnover 194 Receivables Turnover 195 Fixed Asset and Total Asset Turnover 197 Profitability Ratios 198 Leverage Ratios 200 Coverage Ratios 204 Analysis of Financial Statements and the Internet 205 Summary 206 Review Objectives 207 Internet Assignments 207 Problems 207 Additional Problem with Answers 213 Answers 214 f,
Contents Relationships 216 Answers 217 PART 3 Clhapteir 1 Forms of Business and Corporate Taxation 220 Sole Proprietorships, Partnerships, and Corporations 220 S Corporations and Limited Liability Companies (LLC) 223 Corporate Taxation 224 Taxation of Corporate Losses 225 Summary 227 Review Objectives 227 Problems 227 Additional Problems with Answers 228 Answers 229 Chapter 111 Break-Even Analysis and the Payback Period 230 Break-Even Analysis 231 Uses for Break-Even Analysis 234 The Payback Period 235 Summary 236 Review Objectives 237 Problems 237 Additional Problems with Answers 239 Answers 240 Relationships 241 Answers 241 :eir12 Leverage 242 Operating Leverage 243 Fixed Asset Turnover: A Measure of Operating Leverage 243 Operating Leverage and Risk 245 Financial Leverage 247 Financial Leverage and Risk 250 Financial Leverage Through Preferred Stock Financing 253 Summary 254
jdi_ j Contents Review Objectives 254 Problems 255 Additional Problems with Answers 256 Answers 258 Relationships 259 Answers 259 Chapter 13 Cost of Capital 260 Components of the Cost of Capital 261 Cost of Debt 262 Cost of Preferred Stock 2 63 Cost of Common Stock 264 Cost of Capital: A Weighted Average 268 The Optimal Capital Structure 270 The Marginal Cost of Capital 273 The Optimal Capital Structure and the Value of the Firm's Stock 277 Cost of Capital: Review and Problem Areas 279 Summary 280 Review O bj ectives 281 Problems 281 Additional Problems with Answers 284 Answers 285 Relationships 287 Answers 287 Chapter M Capital Budgeting 288 Valuation and Long-Term Investment Decisions 289 Importance of Cash Flow 290 Introduction to Discounted Cash Flow Methods of Capital Budgeting 293 Net Present Value 294 Internal Rate of Return 296 Net Present Value and Internal Rate of Return Compared 299 Ranking Investment Alternatives 301 Differences in the Timing of Cash Flows 302 Differences in Cost 305 ^
Contents L?5*IL The Introduction of Risk into Capital Budgeting 308 Risk Adjustments in Capital Budgeting 310 Adjusting the Discount Rate 313 Summary 316 Review Objectives 317 Problems 318 Additional Problems with Answers 324 Answers 325 Relationships 330 Answers 331 HS Forecasting 332 Planning 333 Fluctuations in Asset Requirements 334 Forecasting External Financial Requirements: Percent of Sales 336 The Percent of Sales Summarized as an Equation 340 Forecasting External Financial Requirements: Regression Analysis 343 Forecasting External Financial Requirements: Changes in Fixed Assets 349 Summary 351 Review Objectives 352 Problems 352 Additional Problems with Answers 358 Answers 361 Relationships 363 Answers 364 0-16 Cash Budgeting 365 The Cash Budget 366 The Differences between a Cash Budget and an Income Statement 367 The Cash Budget Illustrated 367 Summary 371 Review Objectives 372 Problems 372 Additional Problem with Answers 375 Answer 376
Kjfv Contents Relationships 377 Answers 378 Chapter 11 Management of Current Assets 379 Working Capital and Its Management 380 The Impact of the Operating Cycle on Working Capital Policy 381 Financing and Working Capital Policy 383 The Importance of Cash to Working Capital Management 386 The Inventory Cycle 389 The Economic Order Quantity 391 Weaknesses in the EOQ 397 Maximum, Minimum, and Average Inventory 399 Management of Accounts Receivable 399 Credit Policy 400 The Decision to Grant Credit 401 Analyzing Accounts Receivable 403 Cash Management 405 Cash Management Policies 405 Money Market Securities and Yields 406 The Calculation of Yields 407 Summary 409 Review Objectives 409 Problems 410 Additional Problems with Answers 414 Answers 415 Relationships 417 Answers 417 Chapter 118 Management of Short-Term Liabilities 418 Accruals 419 Commercial Bank Loans 419 Cost of Commercial Bank Credit 421 Trade Credit 426 Cost of Trade Credit 427 Commercial Paper 430 i,
Contents Secured Loans 432 Inventory Loans 433 Accounts Receivable Loans 434 Factoring 434 Summary 435 Review Objectives 436 Problems 437 Additional Problems with Answers 439 Answers 439 Relationships 440 Answers 441! jcy Chapter 19 Intermediate-Term Debt and Leasing 442 Intermediate-Term Debt 443 Leasing 446 Lease or Purchase 447 Accounting for Leases 449 Summary 452 Review Objectives 453 Problems 453 Additional Problem with Answer 454 Answer 455 Relationships 457 Answers 457 PART 4 INVESTMENTS 458 r 2 The Features of Stock 460 Equity 461 Common Stock 462 Preemptive Rights 464 Dividend Policy 465 Impact of Transaction Costs 468 Impact of Taxation 469 The Firm's Need for Funding 469
Contents Cash Dividends 470 Stock Dividends 472 Stock Splits 474 Dividend Reinvestment Plans 475 Repurchase of Stock 476 Summary 477 Review Objectives 477 Internet Assignments 477 Problems 478 Additional Problems with Answers 480 Answers 481 Relationships 484 Answers 485 Stock Valuation 486 Valuation of Common Stock: The Present Value and the Growth of Dividends 487 Constant Dividends 487 Growth in the Dividend 488 Uneven Dividend Growth 491 Risk and Stock Valuation 493 Alternative Valuation Techniques: Multiplier Models 496 The Price-to-Earnings Ratio 496 The Price-to-Sales Ratio 497 The Price-to-Book Ratio 498 Stock Valuation and a Word of Caution 498 Summary 498 Review Objectives 499 Internet Assignments 499 Problems 500 Additional Problems with Answers 502 Answers 503 Relationships 504 Answers 504
Contents LISJL The Features of Long-Term Debt Bonds 505 Characteristics of All Debt Instruments 506 Types of Corporate Bonds 508 Mortgage Bonds 509 Equipment Trust Certificates 509 Debentures 509 Income Bonds 510 Convertible Bonds 510 Variable Interest Rate Bonds 511 Zero Coupon Bonds 511 High-Yield Securities Junk Bonds 512 Foreign Bonds 512 Registered and Book Entry Bonds 513 Retiring Debt 513 Serial Bonds 514 Sinking Funds 515 Repurchasing Debt 515 Calling the Debt 516 Government Securities 516 Federal Government Debt 516 Municipal Bonds 518 Summary 519 Review Objectives 520 Bond Pricing and Yields 521 Bond Pricing 522 Using Interest Tables to Determine a Bond's Price 523 Using a Financial Calculator to Determine a Bond's Price 524 The Inverse Relationship between Changes in Interest Rates and Bond Prices 525 Yields 526 The Current Yield 526 The Yield to Maturity 527 A Comparison of the Current Yield and the Yield to Maturity 529 The Yield to Maturity and Returns 530
xviii Contents Summary 530 Review Objectives 530 Problems 531 Additional Problems with Answers 533 Answers 534 Relationships 535 Answers 536 Chapter 24 Preferred Stock 537 The Features of Preferred Stock 537 Preferred Stock and Bonds Contrasted 539 Valuation (Pricing) of Preferred Stock 540 Analysis of Preferred Stock 542 Disadvantages of Preferred Stock from an Investor's Perspective 543 Summary 544 Review Objectives 544 Problems 544 Additional Problems with Answers 545 Answers 546 Relationships 547 Answers 547 r 25 Convertible Securities 548 Features of Convertible Bonds 548 The Valuation of Convertible Bonds 550 The Convertible Bond as Stock 550 The Convertible Bond as Debt 552 The Bond's Value as a Hybrid Security 555 Premiums Paid for Convertible Debt 555 Convertible Preferred Stock 558 Calling Convertibles and Investment Returns 559 Summary 560 Review Objectives 561 Problems 561 Additional Problems with Answers 562 ij
Contents [ jdx^ Answers 563 Relationships 565 Answers 566 Investment Returns 567 The Computation of Returns 568 Historical Investment Returns 571 Summary 572 Review Objectives 573 Problems 573 Additional Problems with Answers 574 Answers 574 Relationships 575 Answers 575 Investment Companies 576 Investment Companies: Origins and Terminology 577 Closed-End Investment Companies 579 Sources of Return from Investing in Closed-End Investment Companies 580 Mutual Funds 581 The Portfolios of Mutual Funds 583 The Portfolios of Specialized Mutual Funds 584 The Returns Earned on Investments in Mutual Funds 586 Studies of Returns 586 Consistency of Returns 588 Selecting a Mutual Fund 589 Fees and Expenses 589 The Timing of Distributions and Income Taxation 590 Tax Efficiency 590 Exchange-Traded Funds (ETFs) 592 Summary 594 Review Objectives 595 Internet Assignments 595 Problems 596
mz, Contents Additional Problems with Answers 597 Answers 597 Relationships 598 Answers 599 PART 5 Chapter 2 Options: Puts and Calls 602 Options 603 The Intrinsic Value of a Call Option 603 Leverage 606 Writing Call Options 610 The Covered Call 610 The Naked Call 612 Put Options 613 Stock Index Options 615 The Volatility Index (The VIX) 617 Summary 618 Review Objectives 618 Internet Assignment 618 Problems 619 Additional Problems with Answers 621 Answers 622 Relationships 623 Answers 623 Chapter 29 Futures and Swaps 624 Futures Contracts 625 The Mechanics of Trading Futures 625 The Units of Commodity Contracts 625 Commodity Positions 626 Reporting of Futures Trading 627 Leverage 629 Hedging 630 Financial and Currency Futures 632 Risk Reduction with Currency Futures Contracts 634 fe
Contents. i KXI Stock Index Futures 636 Swaps 637 Summary 639 Review Objectives 639 Problems 640 Additional Problems with Answers 641 Answers 642 Relationships 643 Answers 643 A Interest Factors for the Future Value of One Dollar 645 IB Interest Factors for the Present Value of One Dollar 647 C Interest Factors for the Future Value of an Annuity of One Dollar 649 Interest Factors for the Present Value of an Annuity of One Dollar 651 E Using Excel to Solve Financial Problems 653 F Answers to Selected Problems 676 Index 685