Description DB- Module 05: Time Value of Money Applications TVM  The Time Value of Money is a fundamental concept used in financial analysis. Explain

DB- Module 05: Time Value of Money Applications
TVM
The Time Value of Money is a fundamental concept used in financial analysis. Explain why it is
important for financial managers to understand and utilize the principles involved.
Provide an example that could be used to illustrate the concept to people who have not
encountered the idea before.
Explain whether you consider it important for people generally to understand the concept as
Saudi Arabia continues to move toward Saudi Vision 2030.
Search the SEU library or the Internet for an academic or industry-related article. Select an
article that relates to these concepts and explain how it relates to doing business in Saudi
Arabia.
Directions:
• Discuss the concepts, principles, and theories from your textbook. Cite your textbooks
and cite any other sources if appropriate.
• Your initial post should address all components of the question with a 500 word limit.
• Reply to at least two discussion posts with comments that further and advance the
discussion topic.does not fulfill these two peer replies but is expected throughout the
course. Answering all course questions is also required.
For Your Success
This module has three primary topics: the valuation of a series of cash flows, return on
investment, and the construction of an amortization schedule. Knowing how to use financial
tools, understanding the premise of present and future value, and being able to analyze loan
terms are important concepts for managers, leaders, and general daily decision-making. In this
module, we will examine and evaluate formulas and variables to examine financing options and
consider how changes in loan and payment terms can impact organizational effectiveness and
your own personal financial management success.
Learning Outcomes
1. Describe the meaning of an ordinary and an annuity due.
2. Calculate the present value and future value annuities.
3. Calculate amortized loan scenarios.
4. Calculate the present value of growing perpetuity.
5. Acquire the skills necessary to use a financial calculator, mathematical formulas, and
Excel spreadsheets.
Readings
Required:
• Chapter 5: The Time Value of Money in Foundations of Finance
• Segal, T. (2023). Common methods of measurement for investment risk
management. Investopedia.
Recommended:
• Chapter 5 PowerPoint Slides
• Fernando, J. (2023). Time value of money (TVM). Investopedia.
Foundations of Finance
Tenth Edition
Chapter 5
The Time Value of Money
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Learning Objectives
5.1 Explain the mechanics of compounding, and bringing the
value of money back to the present.
5.2 Understand annuities.
5.3 Determine the future or present value of a sum when
there are nonannual compounding periods.
5.4 Determine the present value of an uneven stream of
payments and understand perpetuities.
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Compound Interest, Future, and
Present Value
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Using Timelines to Visualize Cash
Flows
Timeline of cash flows
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Compound Interest (1 of 2)
• Compounding is when interest paid on an investment
during the first period is added to the principal; then, during
the second period, interest is earned on the new sum (that
includes the principal and interest earned so far).
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Compound Interest (2 of 2)
• Example: Compute compound interest on $100 invested
at 6% for three years with annual compounding.
– First year interest is $6.00; principal now is $106.00.
– Second year interest is $6.36; principal now is $112.36.
– Third year interest is $6.74; principal now is $119.10.
– Total interest earned: $19.10
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Future Value
• Future value is the amount a sum will grow to in a certain
number of years when compounded at a specific rate.
• FVN = the future of the investment at the end of “n” years
• r = the annual interest (or discount) rate
• n = number of years
• PV = the present value, or original amount invested at the
beginning of the first year
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Future Value Example
• Example: What will be the FV of $100 in 2 years at
interest rate of 6%?
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How to Increase the Future Value?
• Future value can be increased by
– Increasing number of years of compounding (N)
– Increasing the interest or discount rate (r)
– Increasing the original investment (PV)
• See example on next slide.
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Changing R, N, and PV
a. You deposit $500 in bank for 2 years. What is the FV at
2%? What is the FV if you change interest rate to 6%?
b. Continue the same example but change time to 10 years.
What is the FV now?
c. Continue the same example but change contribution to
$1,500. What is the FV now?
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Figure 5.1 $100 Compounded at 6
Percent over 20 Years
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Figure 5.2 The Future of $100 Initially
Deposited and Compounded at 0, 5,
10, and 15 Percent (1 of 2)
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Figure 5.2 The Future of $100 Initially
Deposited and Compounded at 0, 5,
10, and 15 Percent (2 of 2)
• Figure 5.2 illustrates that we can increase the FV by
– Increasing the number of years for which money is
invested
– Investing at a higher interest rate
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Computing Future Values Using
Calculator or Excel
• Review discussion in the textbook.
• Excel Function for FV: = FV(rate, nper, pmt, pv)
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Present Value (1 of 2)
• Present value reflects the current value of a future
payment or receipt.
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Present Value (2 of 2)
FVn = the future value of the investment at the end of n
years
n = number of years until payment is received
r = the interest rate
PV = the present value of the future sum of money
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Present Value Example
• What will be the present value of $500 to be received 10
years from today if the discount rate is 6%?
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Figure 5.3 The Present Value of $100 to
Be Received at a Future Date and
Discounted Back to the Present at 0, 5,
10, and 15 Percent (1 of 2)
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Figure 5.3 The Present Value of $100 to
Be Received at a Future Date and
Discounted Back to the Present at 0, 5,
10, and 15 Percent (2 of 2)
• Figure 5.3 illustrates that PV is lower if
– Time period is longer, or
– Interest rate is higher.
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Using Excel
• Excel Function for PV: = PV(rate,nper,pmt,fv)
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Annuities
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Annuities
• An annuity is a series of equal dollar payments for a
specified number of years.
• Ordinary annuity payments occur at the end of each
period.
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FV of Annuity
Compound Annuity
• Depositing or investing an equal sum of money at the end
of each year for a certain number of years and allowing it
to grow
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FV Annuity Example
What will be the FV of a 5-year, $500 annuity compounded
at 6%?
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Table 5.1 Growth of a 5-Year, $500
Annuity Compounded at 6 Percent
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FV of an Annuity – Using the
Mathematical Formulas (1 of 2)
FVn = the future of an annuity at the end of the nth year
PMT = the annuity payment deposited or received at the end
of each year
r = the annual interest (or discount) rate
n = the number of years
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FV of an Annuity – Using the
Mathematical Formulas (2 of 2)
• What will $500 deposited in the bank every year for 5
years at 6% be worth?
•
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FV of Annuity: Changing PMT, N, and
r (1 of 2)
1. What will $5,000 deposited annually for 50 years be worth
at 7%?
− FV = $2,032,644
− Contribution = $250,000 (= 5000×50)
2. Change PMT = $6,000 for 50 years at 7%
− FV = $2,439,173
− Contribution = $300,000 (= 6000×50)
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FV of Annuity: Changing PMT, N, and
r (2 of 2)
3. Change time = 60 years, $6,000 at 7%
− FV = $4,881,122
− Contribution = $360,000 (= 6000×60)
4. Change r = 9%, 60 years, $6,000
– FV = $11,668,753
– Contribution = $360,000 (= 6000×60)
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Present Value of an Annuity
• Pensions, insurance obligations, and interest owed on
bonds are all annuities. To compare these three types of
investments we need to know the present value (PV) of
each.
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Table 5.2 Illustration of a 5-Year, $500
Annuity Discounted to the Present at
6 Percent
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PV of Annuity – Using the
Mathematical Formulas
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Annuities Due (1 of 2)
• Annuities due are ordinary annuities in which all payments
have been shifted forward by one time period. Thus, with
annuity due, each annuity payment occurs at the beginning
of the period rather than at the end of the period.
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Annuities Due (2 of 2)
• Continuing the same example: If we assume that $500
invested every year for 5 years at 6% to be annuity due,
the future value will increase due to compounding for one
additional year.
•
(versus $2,818.80 for ordinary annuity)
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Amortized Loans (1 of 2)
• Loans paid off in equal installments over time are called
amortized loans.
Examples: Home mortgages, auto loans
• Reducing the balance of a loan via annuity payments is
called amortizing.
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Amortized Loans (2 of 2)
• The periodic payment is fixed. However, different amounts
of each payment are applied toward the principal and
interest. With each payment, you owe less toward
principal. As a result, the amount that goes toward interest
declines with every payment (as seen in Figure 5.4).
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Figure 5.4 The Amortization Process
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Amortization Example
• Example: If you want to finance a new machinery with a
purchase price of $6,000 at an interest rate of 15% over 4
years, what will your annual payments be?
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Finding PMT – Using the
Mathematical Formulas
• Finding Payment: Payment amount can be found by
solving for PMT using PV of annuity formula.
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Table 5.3 Loan Amortization Schedule
Involving a $6,000 Loan at 15 Percent to
Be Repaid in 4 Years
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Making Interest Rates Comparable
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Making Interest Rates Comparable
• We cannot compare rates with different compounding
periods. For example, 5% compounded annually is
not the same as 5% percent compounded quarterly.
• To make the rates comparable, we compute the
annual percentage rate (APR) and the effective
annual rate (EAR).
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Quoted Rate versus Effective Rate
(1 of 2)
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Quoted Rate versus Effective Rate
(2 of 2)
• Quoted rate could be very different from the effective rate if
compounding is not done annually.
• If the APR of a quoted loan is 7.85%, but it is compounded
quarterly, the EAR is actually 8.084%.
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Table 5.4 The Value of $100
Compounded at Various Intervals
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Finding PV and FV with Nonannual
Periods
• If interest is not paid annually, we need to change the
interest rate and time period to reflect the nonannual
periods when computing PV and FV.
– r = stated rate/# of compounding periods
– N = # of years×# of compounding periods in a year
• Example: If your investment earns 10% a year, with
quarterly compounding for 10 years, what should we use
for “r” and “N”?
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The Present Value of an Uneven
Stream and Perpetuities
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The Present Value of an Uneven
Stream
• Some cash flow stream may not follow a conventional
pattern. For example, the cash flows may be erratic (with
some positive cash flows and some negative cash flows)
or cash flows may be a combination of single cash flows
and annuity (as illustrated in Table 5.5).
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Table 5.5 The Present Value of an
Uneven Stream Involving One
Annuity Discounted to the Percent at
6 Percent: An Example
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Table 5.6 Determining the Present
Value of an Uneven Stream Involving
One Annuity Discounted to the
Present at 6 Percent: An Example
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Perpetuity (1 of 2)
• A perpetuity is an annuity that continues forever.
• The present value of a perpetuity is given by
• PV = present value of the perpetuity
• PP = constant dollar amount provided by the perpetuity
• r = annual interest (or discount) rate
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Perpetuity (2 of 2)
• Example: What is the present value of $2,000 perpetuity
discounted back to the present at 10% interest rate?
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Table 5.7 Summary of Time Value of
Money Equation
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Key Terms (1 of 2)
• Amortized loan
• Annual percentage rate (APR)
• Annuity
• Annuity due
• Annuity future value factor
• Annuity present value factor
• Compound annuity
• Compound interest
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Key Terms (2 of 2)
• Effective annual rate (EAR)
• Future value
• Future value factor
• Ordinary annuity
• Nominal or stated interest rate
• Present value
• Present value factor
• Perpetuity
• Simple interest
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Foundations of Finance
The Logic and Practice of Financial Management
Tenth Edition
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Foundations of Finance
The Logic and Practice of Financial Management
Tenth Edition
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
Retired Professor of Finance
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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: Tenth Edition. | New York, NY: Pearson, [2020] | Revised
edition of the authors’ Foundations of finance, [2017] | Includes indexes.
Identifiers: LCCN 2018042981| ISBN 9780134897264 | ISBN 0134897269
Subjects: LCSH: Corporations—Finance.
Classification: LCC HG4026.F67 2019 | DDC 658.15–dc23
LC record available at
1
19
ISBN 10:
0-13-489726-9
ISBN 13: 978-0-13-489726-4
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 Carter and Greg, who are great husbands to our lovely daughters,
Krista and Kate, and the fathers of our five wonderful
grandchildren—Ashley, Cameron, Erin, John, and Mackenzie.
We feel their constant love and friendship.
J. William Petty
About the Authors
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 6 ½ 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 retired from Baylor University where he was the Carr P.
Collins Chair of Finance after having retired earlier from the University of Texas
at Austin where he held the Margaret and Eugene McDermott Professorship in
Finance. He now lives on a small ranch near Crawford, TX where he and his wife
raise Braunvieh-Angus cross cattle, bale a little hay and enjoy life. In his prior life
as professor of finance, John taught for almost a half century earning a number of
teaching awards, published over 50 articles in the leading finance journals, and
coauthored ten books including Financial Management: Principles and Practice
(13th edition, Pearson), Foundations of Finance (10th edition Pearson), Valuation: The
Art and Science of Corporate Investment Decisions (3rd edition, Pearson) and Value
Based Management with Social Responsibility (2nd edition, Oxford University Press).
When not involved in farming and ranching, John feeds his learning habit by
remaining an active researcher and writer. His current research interests focus on
America’s energy dependence problem as it relates to the economics of unconventional energy sources, educating entrepreneurs concerning the true cost of venture
funding, and investigating the economic factors underlying differences in the costs
of capital among emerging economies. Finally, John’s abiding passion is to create
a series of digital books that will meet the evolving needs of the next generation of
college students.
vi
J. William Petty, PhD, Baylor University, was Professor of Finance and
W. W. Caruth Chair of Entrepreneurship from 1990 until 2017. Dr. Petty taught
entrepreneurial finance at both the undergraduate and graduate levels. He was
designated 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 included the financing of entrepreneurial firms and
shareholder value-based management. He 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 served 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.
vii
Brief Contents
Preface
PART 1
1
2
3
4
PART 2
5
6
7
8
9
PART 3
xvii
The Scope and Environment
of Financial Management 2
An Introduction to the Foundations of Financial Management
The Financial Markets and Interest Rates 22
Understanding Financial Statements and Cash Flows 54
Evaluating a Firm’s Financial Performance 100
The Valuation of Financial Assets
The Time Value of Money 142
The Meaning and Measurement of Risk and Return
The Valuation and Characteristics of Bonds 226
The Valuation and Characteristics of Stock 258
The Cost of Capital 284
Investment in Long-Term Assets
186
318
10
11
Capital-Budgeting Techniques and Practice 318
Cash Flows and Other Topics in Capital Budgeting
358
PART 4
Capital Structure and Dividend Policy
398
12
13
Determining the Financing Mix 398
Dividend Policy and Internal Financing
438
PART 5
Working-Capital Management and International
Business Finance 460
14
15
16
Web 17
Short-Term Financial Planning 460
Working-Capital Management 480
International Business Finance 510
Cash, Receivables, and Inventory Management
Available online at www.pearson.com/mylab/finance
Web Appendix A Using a Calculator
Available online at www.pearson.com/mylab/finance
Glossary 532
Indexes 541
viii
142
2
Contents
Preface
PART 1
1
xvii
The Scope and Environment
of Financial Management 2
An Introduction to the Foundations of Financial
Management 2
The Goal of the Firm
3
Five Principles That Form the Foundations of Finance
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
The Essential Elements of Ethics and Trust 9
The Role of Finance in Business
Why Study Finance? 11
The Role of the Financial Manager
4
8
10
11
The Legal Forms of Business Organization
12
Sole Proprietorships 12
Partnerships 13
Corporations 13
Organizational Form and Taxes: The Double Taxation on Dividends
and Pass-Through Entities 14
S-Corporations and Limited Liability Companies (LLCs) 14
Which Organizational Form Should Be Chosen? 15
Finance and the Multinational Firm: The New Role
Developing Skills for Your Career
Chapter Summaries
2
15
16
17 • Review Questions
20 • Mini Case
21
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
ix
x
Contents
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
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
41
Chapter Summaries 47 • Review Questions 50 • Study Problems 50
• Mini Case 53
3
Understanding Financial Statements and Cash
Flows 54
The Income Statement
56
The Makeup of an Income Statement 56
Walmart’s Income Statement 57
Restating Walmart’s Income Statement 59
The Balance Sheet
61
Types of Assets 62
Types of Financing 63
Walmart’s Balance Sheet
Working Capital 66
Measuring Cash Flows
65
69
Profits Versus Cash Flows 69
The Beginning Point: Changes in the Balance Sheet and Cash Flows
Statement of Cash Flows 71
Concluding Suggestions for Computing Cash Flows 78
What Have We Learned about Walmart? 79
70
The Limitations of Financial Statements and Accounting
Malpractice 80
Chapter Summaries 80 • Review Questions 83 • Study Problems 84
• Mini Case 91
Appendix 3A: Free Cash Flows
Computing Free Cash Flows
94
Computing Financing Cash Flows
Study Problems
4
94
96
97
Evaluating a Firm’s Financial Performance
The Purpose of Financial Analysis
100
100
Measuring Key Financial Relationships
103
Question 1: How Liquid Is the Firm—Can It Pay Its Bills? 105
Question 2: Are the Firm’s Managers Generating Adequate Operating Profits on
the Company’s Assets? 110
Managing Operations 112
Managing Assets 112
Question 3: How Is the Firm Financing Its Assets? 117
Question 4: Are the Firm’s Managers Providing a Good Return on the Capital
Provided by the Company’s Shareholders? 120
Question 5: Are the Firm’s Managers Creating Shareholder Value? 124
The Limitations of Financial Ratio Analysis
129
Chapter Summaries 130 • Review Questions 133 • Study Problems 133
• Mini Case 140
Contents
PART 2
5
The Valuation of Financial Assets
The Time Value of Money
142
142
Compound Interest, Future Value, and Present Value
144
Using Timelines to Visualize Cash Flows 144
Techniques for Moving Money Through Time 147
Two Additional Types of Time Value of Money Problems 152
Applying Compounding to Things Other Than Money 153
Present Value 154
Annuities
158
Compound Annuities 158
The Present Value of an Annuity 160
Annuities Due 162
Amortized Loans 163
Making Interest Rates Comparable
165
Calculating the Interest Rate and Converting It to an EAR 167
Finding Present and Future Values With Nonannual Periods 168
Amortized Loans With Monthly Compounding 171
The Present Value of an Uneven Stream and Perpetuities
Perpetuities
Chapter Summaries
• Mini Case 185
6
172
173
174 • Review Questions
177 • Study Problems
177
The Meaning and Measurement of Risk
and Return 186
Expected Return Defined and Measured
Risk Defined and Measured
188
191
Rates of Return: The Investor’s Experience
Risk and Diversification
198
199
Diversifying Away the Risk 200
Measuring Market Risk 201
Measuring a Portfolio’s Beta 208
Risk and Diversification Demonstrated
209
The Investor’s Required Rate of Return
212
The Required Rate of Return Concept 212
Measuring the Required Rate of Return 212
Chapter Summaries
• Mini Case 224
7
215 • Review Questions
219 • Study Problems
219
The Valuation and Characteristics of Bonds
Types of Bonds
227
Debentures 227
Subordinated Debentures
Mortgage Bonds 228
Eurobonds 228
Convertible Bonds 228
228
Terminology and Characteristics of Bonds
Claims on Assets and Income
Par Value 230
Coupon Interest Rate 230
Maturity 230
Call Provision 230
230
229
226
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Contents
Indenture 231
Bond Ratings 231
Defining Value
232
What Determines Value?
234
Valuation: The Basic Process
Valuing Bonds
Bond Yields
235
236
242
Yield to Maturity 242
Current Yield 244
Bond Valuation: Three Important Relationships
Chapter Summaries
• Mini Case 257
8
250 • Review Questions
245
253 • Study Problems
254
The Valuation and Characteristics of Stock
Preferred Stock
260
The Characteristics of Preferred Stock
Valuing Preferred Stock
Common Stock
258
260
261
265
The Characteristics of Common Stock
Valuing Common Stock
265
267
The Expected Rate of Return of Stockholders
272
The Expected Rate of Return of Preferred Stockholders 273
The Expected Rate of Return of Common Stockholders 274
Chapter Summaries
• Mini Case 283
9
277 • Review Questions
The Cost of Capital
280 • Study Problems
280
284
The Cost of Capital: Key Definitions and Concepts
285
Capital Structure 285
Opportunity Costs, Required Rates of Return, and the Cost of Capital
The Firm’s Financial Policy and the Cost of Capital 287
286
Determining the Costs of the Individual Sources of Capital
The Cost of Debt 288
The Cost of Preferred Stock 291
The Cost of Common Equity 292
The Dividend Growth Model and the Implied Cost of Equity
Issues in Implementing the Dividend Growth Model 294
The Capital Asset Pricing Model 295
Issues in Implementing the CAPM 296
The Weighted Average Cost of Capital
298
Capital Structure Weights 298
Calculating the Weighted Average Cost of Capital
Calculating Divisional Costs of Capital
293
299
301
Estimating Divisional Costs of Capital 301
Using Pure Play Firms to Estimate Divisional WACCs 301
Using a Firm’s Cost of Capital to Evaluate New Capital Investments
Chapter Summaries 307 • Review Questions
• Mini Cases 316
310 • Study Problems
305
310
288
Contents
PART 3
10
Investment in Long-Term Assets
318
Capital-Budgeting Techniques and Practice
Finding Profitable Projects
318
319
Capital-Budgeting Decision Criteria
320
The Payback Period 320
The Net Present Value 324
Using Spreadsheets to Calculate the Net Present Value 327
The Profitability Index (Benefit–Cost Ratio) 327
The Internal Rate of Return 330
Computing the IRR for Uneven Cash Flows with a Financial Calculator 332
Viewing the NPV–IRR Relationship: The Net Present Value Profile 333
Complications with the IRR : Multiple Rates of Return 334
The Modified Internal Rate of Return (MIRR)2 335
Using Spreadsheets to Calculate the MIRR 338
A Last Word on the MIRR 339
Capital Rationing
339
The Rationale for Capital Rationing 340
Capital Rationing and Project Selection 341
Ranking Mutually Exclusive Projects
341
The Size-Disparity Problem 342
The Unequal-Lives Problem 343
Chapter Summaries
• Mini Case 356
11
346 • Review Questions
349 • Study Problems
350
Cash Flows and Other Topics in Capital
Budgeting 358
Guidelines for Capital Budgeting
359
Use Free Cash Flows Rather Than Accounting Profits 359
Think Incrementally 359
Beware of Cash Flows Diverted from Existing Products 360
Look for Incidental or Synergistic Effects 360
Work in Working-Capital Requirements 360
Consider Incremental Expenses 361
Remember That Sunk Costs Are Not Incremental Cash Flows 361
Account for Opportunity Costs 361
Decide If Overhead Costs Are Truly Incremental Cash Flows 361
Ignore Interest Payments and Financing Flows 362
Calculating a Project’s Free Cash Flows
362
What Goes into the Initial Outlay 362
What Goes into the Annual Free Cash Flows over the Project’s Life
What Goes into the Terminal Cash Flow 365
Calculating the Free Cash Flows 366
A Comprehensive Example: Calculating Free Cash Flows 370
Options in Capital Budgeting
374
The Option to Delay a Project 374
The Option to Expand a Project 375
The Option to Abandon a Project 376
Options in Capital Budgeting: The Bottom Line
Risk and the Investment Decision
376
376
What Measure of Risk Is Relevant in Capital Budgeting? 377
Measuring Risk for Capital-Budgeting Purposes with a Dose
of Reality—Is Systematic Risk All There Is? 378
Incorporating Risk into Capital Budgeting 379
Risk-Adjusted Discount Rates 379
Measuring a Project’s Systematic Risk 382
363
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Contents
Using Accounting Data to Estimate a Project’s Beta 382
The Pure Play Method for Estimating Beta 383
Examining a Project’s Risk Through Simulation 383
Conducting a Sensitivity Analysis Through Simulation 385
Chapter Summaries
• Mini Case 394
386 • Review Questions
388 • Study Problems
388
Appendix 11A: The Modified Accelerated Cost
Recovery System 396
What Does All This Mean?
Study Problems
PART 4
12
397
397
Capital Structure and Dividend Policy
Determining the Financing Mix
398
398
Understanding the Difference Between Business
and Financial Risk 400
Business Risk 401
Operating Risk 401
Break-Even Analysis
401
Essential Elements of the Break-Even Model
Finding the Break-Even Point 404
The Break-Even Point in Sales Dollars 405
Sources of Operating Leverage
402
406
Financial Leverage 408
Combining Operating and Financial Leverage
Capital Structure Theory
410
412
A Quick Look at Capital Structure Theory 414
The Importance of Capital Structure 414
Independence Position 414
The Moderate Position 416
Firm Value and Agency Costs 418
Agency Costs, Free Cash Flow, and Capital Structure
Managerial Implications 420
420
The Basic Tools of Capital Structure Management
421
EBIT-EPS Analysis 421
Comparative Leverage Ratios 424
Industry Norms 425
Net Debt and Balance-Sheet Leverage Ratios 425
A Glance at Actual Capital Structure Management 425
Chapter Summaries 428 • Review Questions
• Mini Cases 434
13
431 • Study Problems
Dividend Policy and Internal Financing
432
438
How do Firms Distribute Firm Profits to their Stockholders?
Does Dividend Policy Matter to Stockholders?
Three Basic Views 440
Making Sense of Dividend Policy Theory
What Are We to Conclude? 445
442
The Dividend Decision in Practice
446
Legal Restrictions 446
Liquidity Constraints 446
Earnings Predictability 446
440
439
Contents
Maintaining Ownership Control 447
Alternative Dividend Policies 447
Dividend Payment Procedures 447
Stock Dividends and Stock Splits
Stock Repurchases
448
449
A Share Repurchase as a Dividend Decision 450
The Investor’s Choice 451
A Financing Decision or an Investment Decision? 452
Practical Considerations—The Stock Repurchase Procedure
Chapter Summaries
• Mini Case 459
PART 5
14
453 • Review Questions
452
455 • Study Problems
456
Working-Capital Management and International
Business Finance 460
Short-Term Financial Planning
Financial Forecasting
460
461
The Sales Forecast 461
Forecasting Financial Variables 461
The Percent of Sales Method of Financial Forecasting 462
Analyzing the Effects of Profitability and Dividend Policy on DFN
Analyzing the Effects of Sales Growth on a Firm’s DFN 464
Limitations of the Percent of Sales Forecasting Method
Constructing and Using a Cash Budget
463
467
468
Budget Functions 468
The Cash Budget 469
Chapter Summaries
15
471 • Review Questions
473 • Study Problems
Working-Capital Management
480
Managing Current Assets and Liabilities
481
473
The Risk–Return Trade-Off 482
The Advantages of Current versus Long-term Liabilities: Return 482
The Disadvantages of Current versus Long-term Liabilities: Risk 482
Determining the Appropriate Level of Working
Capital 483
The Hedging Principle 483
Permanent and Temporary Assets 484
Temporary, Permanent, and Spontaneous Sources of Financing
The Hedging Principle: A Graphic Illustration 484
Using the Cash Conversion Cycle
484
486
Estimating the Cost of Short-Term Credit Using the Approximate
Cost-of-Credit Formula 488
Evaluating Sources of Short-Term Credit
490
Unsecured Sources: Accrued Wages and Taxes 490
Unsecured Sources: Trade Credit 492
Unsecured Sources: Bank Credit 493
Finance at Work 495
Unsecured Sources: Commercial Paper 496
Secured Sources: Accounts-Receivable Loans 498
Secured Sources: Inventory Loans 500
Chapter Summaries
501 • Review Questions
504 • Study Problems
505
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Contents
16
International Business Finance
510
The Globalization of Product and Financial Markets
511
Foreign Exchange Markets and Currency Exchange Rates
Foreign Exchange Rates 513
What a Change in the Exchange Rate Means for Business
Exchange Rates and Arbitrage 516
Asked and Bid Rates 516
Cross Rates 517
Types of Foreign Exchange Transactions 518
Exchange Rate Risk 520
Interest Rate Parity
513
522
Purchasing-Power Parity and the Law of One Price
The International Fisher Effect
Capital Budgeting for Direct Foreign Investment
Repatriation of Profits and Taxation of Profits Abroad
Foreign Investment Risks 525
Chapter Summaries
• Mini Case 530
523
524
526 • Review Questions
524
525
529 • Study Problems
Web 17 Cash, Receivables, and Inventory
Management
Available online at www.pearson.com/mylab/finance
Web Appendix A
Using a Calculator
Available online at www.pearson.com/mylab/finance
Glossary 532
Indexes 541
529
512
Preface
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
originally 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 materials 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 expectations for nine 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 Tenth Edition
Many of the changes in the 10th edition stem from comments and suggestions made
by adopters, and we thank them for all they have done to improve this edition. Other
changes were inspired by the passage of the Tax Cuts and Jobs Act of 2017. This new
law brought sweeping changes to corporate taxes. Some of the tax changes that that
will impact corporate finance decisions include a dramatic reduction in the corporate
tax rate, the ability to depreciate the full purchase price of capital investments in the
year the investment is put into service, a limitation on the tax deductibility of interest
payments, and a change in the taxation of foreign profits. Needless to say, the impact
of these tax changes ripple throughout the book. For example, corporate decision
making, with respect to new investments in new projects and how those projects are
financed, are impacted by the new tax law.
In addition to the integration of the new tax law throughout the book, we have
made some chapter-by-chapter updates in response to the continued development
of financial thought and reviewer comments. By chapter, some of these changes
include:
Chapter 1
An Introduction to the Foundations of Financial Management
◆ Revised and updated chapter introduction
◆ Revised and updated section on the Organizational Form and Taxes to include
changes resulting from the new tax laws and changes to pass-through entities
Chapter 2
The Financial Markets and Interest Rates
◆ Revised and updated chapter introduction
◆ Revised coverage to include recent changes in the financial markets
◆ Updated coverage of the term structure of interest rates to address the very low
rates that characterize today’s markets
xvii
xviii
Preface
Chapter 3
Understanding Financial Statements and Cash Flows
◆ Streamlined bullet point presentations that can be reviewed by the reader to
quickly grasp new concepts
◆ Updated to illustrate the principles of financial statements, using a company that
will be of interest to students—Walmart
◆ Rather than merely present Walmart’s financial statements in isolation, background material is provided about Walmart that will give context to the company’s financials
Chapter 4
Evaluating a Firm’s Financial Performance
◆ Streamlined chapter presentation makes it easier for the reader to review the process used in conducting the analysis
◆ Comparative financial performance analysis provided using retail giants Walmart
and Target
Chapter 5
The Time Value of Money
◆ Revised to make the subject matter more accessible to all students regardless of
their level of mathematical skill
◆ Expanded problem set
Chapter 6
The Meaning and Measurement of Risk and Return
◆ Updated to show an illustration of the large differences in returns over the time
periods of 2007–2009, 2009–2018, and 2007–2018
◆ Provides an examination of average rates of return and the variability of the returns for different types of securities, such as government bonds, corporate bonds
and stock for 90 years, from 1926 to 2016
◆ Updated to show examples of firms like Nike and eBay, which clearly illustrate
the chapter concepts.
◆ Includes a new mini-case highlighting Walmart and Target
Chapter 7
The Valuation and Characteristics of Bonds
◆ Provides additional real-world examples
◆ A new Finance at Work feature describes a bond issued by Apple called a green bond
Chapter 8
The Valuation and Characteristics of Stock
◆ Revised to descibe the events leading to Netflix becoming one of the most highly
valued stocks in the marketplace
◆ The Finance at Work box has been revised on reading stock quotes in the Wall Street
Journal
◆ Includes updated chapter examples
Chapter 9
The Cost of Capital
◆ All illustrative examples have been updated to reflect changed financial conditions
◆ Includes an updated discussion of tax considerations to reflect the 2017 revision
to the U. S. tax code, which imposes a maximum corporate tax rate of 21 percent
Preface
◆ New Finance at Work insert discusses the new tax law and limitations to the deductibility of interest expense to a maximum of 30 percent of firm earnings before
interest and taxes plus depreciation and amortization (EBITDA)
◆ Figure revision illustrates the dramatic differences in capital structures used by
firms in very different types of industries to reflect the current capital structures
of retailer Bed, Bath and Beyond (BBBY) and oil and gas production company,
Wildhorse Resources (WRD)
Chapter 10
Capital-Budgeting Techniques and Practice
◆ Includes an extensively revised chapter introduction, which looks at Disney’s decision to build the Shanghai Disney Resort
◆ Offers a simplified, intuitive discussion of the IRR and MIRR
◆ Offers a simplified, intuitive discussion of the ranking of mutually exclusive projects
◆ Includes an expanded problem set.
Chapter 11
Cash Flows and Other Topics in Capital Budgeting
◆ Revised the calculation of operating cash flows to reflect the changes resulting
from passage of the Tax Cuts and Jobs Act of 2017, in particular bonus depreciation
◆ Includes revised examples and problems, which reflect the change in the calculation of depreciation
◆ Includes an expanded problem set.
Chapter 12
Determining the Financing Mix
◆ Offers a revised chapter introduction using a comparison of social media firm,
Snap Inc. and computer chip maker, Broadcom (AVGO)
◆ Revised problem examples and end-of-chapter exercises reflect the tax code revision of 2017
◆ A new mini-case that analyzes the capital structure of Wildhorse Resources (WRD)
focuses on whether a bank should agree to a loan extension for the firm considering its current capital structure and operating conditions
Chapter 13
Dividend Policy and Internal Financing
◆ Updated discussion of dividend policy reflects the revision to the U.S. tax code
◆ A streamlined discussion of tax implications for dividend policy focuses on the
applicable tax rates for dividends and capital gains
◆ Revised end-of-chapter study problems reflect changes in the tax code
Chapter 14
Short-Term Financial Planning
◆ Revised end-of-chapter problems and in-chapter examples reflect changes to the
U.S. tax code
Chapter 15
Working-Capital Management
◆ New Finance at Work insert evaluates the cost of Payday loans using the same
method used to evaluate the cost of trade credit. Students will be surprised to see
how expensive these loans are and the fact that they are indeed legal
xix
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Preface
Chapter 16
International Business Finance
◆ Extensive revisions reflect changes in exchange rates and global financial
markets
◆ A new section titled “Repatriation of Profits and Taxation of Profits Abroad”
deals with the changes resulting from the passage of the Tax Cuts and Jobs Act
of 2017
Web Chapter 17
Cash, Receivables, and Inventory Management
◆ Discussion of cash management has been simplified and reduced in coverage so
that students can more easily grasp the important concepts underlying its management
The Foundations of Finance Tenth
Edition Program
The 10th Edition of Foundations of Finance continues its drive to provide the student
with an intuitive understanding of financial management while providing them with
the concepts and skills needed for the successful manager. An understanding that
emphasizes the logic and fundamental principles that drive the field of finance allows students to effectively deal with financial problems in an ever-changing financial enviromement.
To improve student results, we recommend pairing the text content with MyLab
Finance, which is the teaching and learning platform that empowers you to reach
every student. By combining trusted author content with digital tools and a flexible
platform, MyLab personalizes the learning experience and will help your students
learn and retain key course concepts while developing skills that future employers
are seeking in their candidates. Select end-of-chapter problems in the text are now
offered in MyLab Finance as auto-graded Excel Projects. Using proven, field-tested
technology, auto-graded Excel Projects allow instructors to seamlessly integrate Microsoft Excel content into their course without having to manually grade spreadsheets. Students have the opportunity to practice important finance skills in Excel,
helping them to master key concepts and gain proficiency with the program.
Another form of learning technology offered with this course is the lecture
video. We have recorded brief (10–15 minute) lecture videos to accompany all the
numbered in-text examples so that the students can replay them as many times as
they need to help them understand more fully each of the in-text examples. Students will benefit from being “tutored” when it comes to the primary examples in the
text. The videos can be found in the Multimedia Library as well as the eText within
MyLab Finance.
Solving Teaching and Learning
Challenges
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 understanding 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 memorizing formulas and procedures. As a result, students
have a difficult time understanding the interrelationships among the topics covered.
Moreover, later in life, when the problems encountered do not match the textbook
Preface
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 ten editions to include the following features.
Building on Foundational Finance Principles
Chapter 1 presents five foundathe basic
Five Principles That Form the Foundations
LO2 Understand
principles of finance,
tional principles of finance which
their importance, and the
of Finance
importance of ethics and trust.
are the threads that bind all the topTo the first-time student of finance, the subject matter may seem like a collection of
ics of the book. Then throughout
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 princithe text, we provide reminders of
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
the foundational principles in “Restockholders).
member Your Principles” boxes.
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
The five principles of finance
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 techallow us to provide an introduction
niques presented in this text, and thereby allowing us to focus on the logic underlyto financial decision making rooted
ing the practice of financial management. Now let’s introduce the five principles.
in current financial theory and in
Principle 1: Cash Flow Is What Matters
1
the current state of world economic
You probably recall from your accounting classes that a company’s profits can differ
conditions. What results is an introdramatically from its cash flows, which we will review in Chapter 3. But for now
ductory treatment of a discipline
rather than the treatment of a series of isolated financial problems that managers
encounter.
PRINCIPLE
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 foundation for the valuation of any investment.
◆ We introduce new topics in the
context of “what is the value
proposition?” and “how is the
CHAPTER
An Introduction to
value of the enterprise affected?”
the Foundations of
1
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 been
carefully prepared to stimulate student interest in the topic to come
and can be used as a lecture tool to
provoke class discussion.
Financial Management
Learning Objectives
LO1
Identify 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
The Goal of the Firm
LO4
Distinguish among the different legal forms
of business organization.
The Legal Forms of Business
Organization
LO5
Explain what has led to the era of the multinational
corporation.
Finance and the Multinational
Firm: The New Role
LO6
Describe how this course and the skills you will
develop in it will help you in your career and in
your life.
Developing Skills for Your Career
A
pple 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, Apple stock was selling for 50 cents per
share and 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,
22 years later, in 2018, the price of Apple’s common stock was up to $180 per share,
climbing about 360 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.
2
Between the introduction of the iPod in
October 2001 and the beginning 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 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 and
revising your products, and you keep
developing and introducing new products that consumers want—the iPhone. With this in mind, in September 2017, Apple
unveiled its iPhone 8 and iPhone X, which immediately dominated smart phone
sales, accounting for 61 percent of smartphone sales in the fourth quarter of 2017.
In effect, Apple seems to have a never-ending supply of new, exciting products that
we all want. In 2014 Apple bought Beats for $3 billion; then in April 2015, Apple introduced the Apple Watch; and while there have been rumors about introducing an
Apple Car in 2020s, it now looks like Apple is gearing up to release an augmented reality headset in the near future. Through all of this, Apple has developed and expanded
its services including Apple Pay, Apple Music, the iTunes Store, and iCloud to the point
where, in 2018, these new services account for about 16 percent of their total revenue.
How did Apple make the decision to introduce the original iPod and then 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 creating 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 borrow 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 management 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
LO1
Identify 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 shareholders by making decisions that will maximize the price of the existing common stock.
3
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Preface
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 formulas 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 structured three-step
STEP 1: Formulate a Decision Strategy
approach to problem solving that helps
A company’s financing decisions can be evaluated by considering two questions: (1) How
students develop their problem-solving
much debt is used to finance the firm’s assets? (2) Does a company have the ability to
service its debt interest payments? These two issues can be assessed by using the debt
skills:
ratio and the times interest earned ratio, respectively, calculated as follows:
Debt ratio =
total debt
total assets
Times interest earned =
operating profits
interest expense
STEP 2: Crunch the Numbers
A comparison of Disney’s debt ratio and times interest earned with the industry is
as follows:
Disney
Industry
56%
34.21%
36.81X
8.50X
Debt ratio
Times interest earned
STEP 3: Analyze Your Results
Disney uses significantly more debt financing than the average firm in the industry. The
higher debt ratio implies that the firm has greater financial risk. Even so, Disney appears
to have no difficulty servicing its debt, covering its interest 36.81 times compared only to
8.5 times for the average firm in the industry. Disney’s higher times interest earned is attributable to a significantly higher operating return on its assets (14.79% for Disney and
9.24% for the industry), which more than offsets the firm’s use of more debt.
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.)
DID YOU GET IT?
Solving for the Real Rate of Interest
Nominal or quoted
rate of interest
5
real rate of
interest
1
anticipated rate
of inflation
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%
Step 1: Formulate a Solution Strategy. For
example, what is the appropriate formula
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?,” followed 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.
Preface
Concept Check
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.
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?
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 equation 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 presentation of the time value of money and
valuation. 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.
FIN AN CIAL DE CIS ION TOOL S
Name of Tool
Bond value when
interest is paid
semiannually
Formula
$I1 > 2
$I2 > 2
$I3 > 2
What It Tells You
$I2n > 2
$M
+
+
+ g +
+
Vb =
rb 2
rb 3
rb 2n
rb 2n
rb 1
a1 + b
a1 + b
a1 + b
a1 + b
a1 + b
2
2
2
2
2
Calculates the value of a
bond as the present value of
both future interest payments
received semiannually and the
par value of the bond to be
received at maturity.
CALCULATOR SOLUTION
Data Input
Function Key
360
N
6.5/12
– 1,250
I/Y
0
FV
PMT
Function Key
Answer
CPT
PV
197,763.52
Chapter Summaries
LO1 Explain the purpose and importance of financial analysis.
SUMMARY: A variety of groups find financial ratios useful. For instance, both man –
agers and shareholders use them to measure and track a company’s performance
over time. Financial analysts outside of the firm who have an interest in its eco nomic well-being also use financial ratios. An example of this group would be a
loan officer of a commercial bank who wishes to determine the creditworthiness of
a loan applicant and its ability to pay the interest and principal associated with the
loan request.
KEY TERMS
Financial ratios, page 101 accounting data
restated in relative terms to help people
identify some of the financial strengths and
weaknesses of a company.
Revised Study Problems
With each edition, we have provided new and
revised end-of-chapter study problems to refresh their usefulness in teaching finance. Also, the study problems continue to be organized according to learning objective so that
both the instructor and student can readily align text and
problem materials. New to this edition, the Study Problems
with Excel icons indicate that Auto Graded Excel Project
spreadsheets are available in MyLab Finance.
10-12. (NPV with different required rates of return) Mooby’s is considering building a
new theme park. After future cash flows were estimated, but before the project could
be evaluated, the economy picked up and with that surge in the economy interest rates rose. That rise in interest rates was reflected in the required rate of return
Mooby’s used to evaluate new projects. As a result, the required rate of return for
the new theme park jumped from 9.5 percent to 11.00 percent. If the initial outlay for
the park is expected to be $250 million and the project is expected to return free cash
flows of $50 million in years 1 through 5 and $75 million in years 6 and 7, what is
the project’s NPV using the new required rate of return? How much did the project’s
NPV change as a result of the rise in interest rates?
10-13. (IRR with uneven cash flows ) The Tiffin Barker Corporation is considering
X
MyLab introducing a new currency verifier that has the ability to identify counterfeit dollar
bills. The required rate of return on this project is 12 percent. What is the IRR on this
project if it is expected to produce the following free cash flows?
X
MyLab
xxiii
xxiv
Preface
Mini Case
Comprehensive Mini Cases
This Mini Case is available in MyLab Finance.
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.
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 determining 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.
Additional MyLab Finance Features
A Powerful Homework and Test Manager. A powerful
homework and test manager lets you create, import, and
manage online homework assignments, quizzes, and tests
that are automatically graded. You can choose from a wide
range of assignment options, including time limits, proctoring, and maximum number of attempts allowed. The
bottom line: MyLab Finance means less time grading and more time teaching. Please
visit www.pearson.com/mylab/finance to access the full set of features available in
MyLab Finance.
Study Plan. The Study Plan gives personalized recommendations for each student,
based on his or her ability to master the learning objectives in your course. This allows students to focus their study time by pinpointing the precise areas they need to
review, and allowing them to use customized practice and learning aids — such as
videos, eTexts, tutorials, and more — to help students stay on track.
Pearson eText. Pearson eText enhances learning — both in and out of the classroom.
Students can take notes, highlight, and bookmark important content, or engage with
interactive lecture and example videos that bring learning to life anytime, anywhere
via MyLab or the app. Pearson eText enhances learning — both in and out of the
classroom. Worked examples, videos, and interactive tutorials engage students while
algorithmic practice and self-assessment opportunities test students’ understanding
of the material via MyLab or the app.
Learning Management System (LMS) Integration. You can now link from Blackboard Learn, Brightspace by D2L, Canvas, or Moodle to MyLab Finance. Access
assignments, rosters, and resources, and synchronize grades with your LMS gradebook. For students, single sign-on provides access to all the personalized learning
resources that make studying more efficient and effective.
Excel Projects. Using proven, field-tested technology, auto-graded Excel Projects
let you seamlessly integrate Microsoft Excel content into your course without having to manually grade spreadsheets. Students can practice important statistical skills
in Excel, helping them master key concepts and gain proficiency with the program.
They simply download a spreadsheet, work live on a statistics problem in Excel, and
then upload that file back into MyLab Finance. Within minutes, they receive a report
that provides personalized, detailed feedback to pinpoint where they went wrong in
the problem.
Financial Calculator. Students can access a fully functional Financial Calculator inside MyLab Finance and a financial calculator app that they can download to their
iPhone®, iPad®, or Android device — so they can perform financial calculations and
complete assignments, all in the same place.
Preface
Question Help. Question Help consists of homework and practice questions to give
students unlimited opportunities to master concepts. If students get stuck, learning
aids like Help Me Solve This, View an Example, eText Pages, and a Financial Calculator walk them through the problem and show them helpful info in the text — giving
them assistance when they need it most.
Worked Out Solutions. Worked Out Solutions are available to students when they
are reviewing their submitted and graded homework. They provide step-by-step
explanations on how to solve the problem using the exact numbers and data presented in the original problem. Instructors have access to Worked Out Solutions in
preview and review mode.
Please visit www.pearson.com/mylab/finance to access the full set of features
available in MyLab Finance.
Developing Employability Skills
For students to succeed in a rapidly changing job market, they should be aware
of their career options and how to go about developing the necessary skills. With
MyLab Finance and Foundations of Finance, we focus on developing these skills in the
following ways:
Excel Skills Today, Excel is the primary spreadsheet analysis and modeling tool
used in business, and a basic competence in Excel will go a long way towards a successful business career. The power to import data from various files and documents
makes Excel the perfect tool for business analysis. In MyLab Finance, there are numerous problems available as auto-graded Excel Projects, which are identified in the
text with an Excel icon. Using proven, field-tested technology, these projects seamlessly integrate Microsoft Excel content into the course while avoiding the need to
manually grade spreadsheets. This feature allows students the opportunity to practice important finance skills in Excel, helping them to master key concepts and gain
proficiency with the program.
Critical Thinking Skills This text begins with the presentation of five foundational
principles of finance, which are the threads that bind all the topics of the book. Then,
throughout the book, these five foundational principles are revisited in “Remember
Your Principles” boxes. These five principles of finance allow us to tie the material
together and, as a result, demonstrate the common root of financial theory and financial practice. The end result is an introductory treatment of a discipline rather
than the treatment of a series of isolated financial problems that managers encounter.
This approach allows students to learn more than simply how to calculate the correct
answers to problems. It allows them to understand why problems are approached
in different ways and to critically interpret problems, design solutions, and analyze
and evaluate their solutions. In effect, students learn the tools of analysis, but more
importantly, develop an intuitive understanding of why and what they are doing in
their analysis. To conduct this analysis, forecast the future, and discount those cash
flows, they must make many assumptions about specific variables. By tying together
the logic and fundamental principles that drive the field of finance, students are encouraged to develop their critical thinking skills and effectively deal with financial
problems in an ever-changing financial environment.
Data Analysis Skills Finance deals with decision making within the firm—when to
introduce a new product, make an investment, or how to value a financial asset like a
bond or a share of common stock. Gaining an understanding of the decision-making
process and the analytical tool set necessary to make those decisions reflects the core
of finance and this text.
xxv
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Preface
Table of Contents Overview
Part 1 The Scope and Environment of Financial Management
1 An Introduction to the Foundations of Introduces the framework for the maintenance and creation of shareholder wealth,
Financial Management
which should be the goal of the firm and its managers, followed by a look at the basic
principles of finance. The different legal forms of organization are also discussed
along with multinational corporations.
2 The Financial Markets and Interest Examines key components of the US financial market system and the financing of
Rates
business, and the process of raising funds in capital markets. Historical rates of
return are examined along with the fundamentals of interest rate determination.
3 Understanding Financial Statements Financial statements are in some ways the “language of business.” As a manager,
and Cash Flows
there are simply some things about a business that can only be understood through
a firm’s financial statements. This chapter examines the three basic financial statements that are used to understand how a firm is doing financially, including (1)
income statements, (2) balance sheets, and (3) statements of cash flows.
4 Evaluating a Firm’s Financial Perfor- Identifies important financial relationships of interest to managers, lenders, and
mance
shareholders to give more meaning to the financial statements.
Part 2 The Valuation of Financial Assets
5 The Time Value of Money
Examines the time value of money, looking at calcuations associated with moving
money through time.
6 The Meaning and Measurement of Risk Explains the nature of risk and how risk should relate to expected returns on investand Return
ments.
7 The Valuation and Characteristics of Explains how bonds and stocks are valued in the marketplace; identifies the different
Bonds
kinds of bonds and their features; and examines the procedures for valuing an asset
and applying these ideas to valuing bonds.
8 The Valuation and Characteristics of Focuses on the characteristics of common and preferred stocks, and examines how
Stock
to value them using the same concept for valuing both preferred stock and common
stock.
9 The Cost of Capital
The cost of capital is a key determinant of whether a firm’s investment choices will
create value for the firm’s stockholders. In this chapter we evaluate a firm’s overall
cost of capital and discuss the estimation of divisional costs of capital.
Part 3 Investment in Long-Term Assets
10 Capital-Budgeting Techniques and Presents capital-budgeting techniques, including the payback period, discounted
Practice
payback period, net present value, internal rate of return, and the modified internal
rate of return.
11 Cash Flows and Other Topics in Capi- Presents cash flow guidelines and examines the calculation of a project’s free cash
tal Budgeting
flows; focuses on options in capital budgeting, closing with an examination of risk
and the investment decision.
Part 4 Capital Structure and Dividend Policy
12 Determining the Financing Mix
When firms make investment decisions they must simultaneously decide what investments to undertake and how they will finance those investments. In this chapter
we investigate the factors underlying the decision process that sometimes leads the
firms to borrow money and at other times issue new shares of stock.
13 Dividend Policy and Internal Financ- Dividend policy and a firm’s decision to retain earnings to help finance its investing
ments are opposite sides of the same coin. A decision to pay out a portion of firm
earnings to its stockholders in the form of a cash dividend or a stock repurchase is a
decision not to retain those earnings and reinvest them in the firm. In this chapter we
review various theories concerning why firms choose to pay cash dividends or retain
and reinvest earnings.
Preface
Part 5 Working-Capital Management and International Business Finance
14 Short-Term Financial Planning
In order to assure that the firm has the funds it needs to support its day-to-day
operations, it is crucial that it forecast those financing needs as part of its planning process. In this chapter we discuss the percent of sales method for preparing a
financial forecast as well as the cash budget.
15 Working-Capital Management
Overviews working capital management as it relates to the analysis of the firm’s
investment in short-term or current assets and its use of short-term or current liabilities. Discusses how the balancing of these two accounts will determine the ability of
the firm to pay its bills on time or firm liquidity.
16 International Business Finance
Examines foreign exchange markets and currency exchange rates; the concepts of
interest rate parity, purchashing power parity, and the law of one price; and capital
budgeting for direct foreign investment.
Web 17 Cash, Receivables, and Inven- Discusses the theory behind managing a firm’s liquidity by managing its working
tory Management
capital and the fact that this is primarily accomplished by the management of cash,
accounts receivables, and inventories.
Instructor Teaching Resources
The Instructor’s Resource Center, accessible at hosts all of the instructor resources that follow. Instructors can register online for access or may contact their sales representative for
further information.
Supplements available to instructor at
www.pearsonhighered.com/irc
Features of the Supplement
Instructor’s Resource Manual
• Chapter orientations
Authored by Sonya Britt-Lutter from Kansas State University • Chapter outlines
• Solutions to end-of-chapter Review Questions, Study Problems, and Mini
Cases, as well as any associated Excel files
Test Bank
More than 1600 multiple-choice, true/false, short-answer, and graphing
Authored by Rodrigo J. Hernandez from Radford University Questions with these annotations:
• Type (multiple-choice, true/false, short-answer, essay
• Topic (the term or concept the question supports)
• Learning outcome
• AACSB learning standard (written and oral communication; ethical
understanding and reasoning; analytical thinking; information technology; interpersonal relations and teamwork; diverse and multicultural work;
reflective thinking; application of knowledge)
Computerized TestGen
TestGen allows instructors to:
• Customize, save, and generate classroom tests
• Edit, add, or delete questions from the test item files
• Analyze test results
• Organize a database of tests and student results.
PowerPoints
PowerPoints include lecture notes, key equations, and figures and tables from
Authored by Sonya Britt-Lutter from Kansas State University the text. In addition, these the slides meet accessibility standards for students
with disabilities. Features include, but are not limited to:
• Keyboard and screen reader access
• Alternative text for images
• High color contrast between background and foreground colors
xxvii
xxviii
Preface
Acknowledgments
We gratefully acknowledge the assistance, support, and encouragement of those individuals who have contributed to Foundations of Finance. Specifically, we wish to recognize the very helpful insights provided by many of our colleagues. For this edition,
we are especially grateful to the following reviewers for their thoughtful comments:
Nazli Alan, Fairfield University
Paul Bursik, St. Norbert College
Jonathan Daigle, Monmouth University
Puneet Jaiprakash, Minnesota State
University Mankato
Hui Liang James, University of
Texas at Tyler
Sophie Kong, Western Washington
University
Stephen Levkoff, Hampden Sydney
College
Andrew Wagner Cal State University Stanislaus
Ann Marie Whyte, University of
Central Florida
We are also indebted to many other professionals for their careful reviews and
helpful comments in past editions:
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
Preface
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
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
We also thank our friends at Pearson. They are a great group of folks. We offer our
personal expression of appreciation to Vice President, Business, Economics, and UK
Courseware 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 previous finance editor. Kate’s energy,
drive, and amazing insights taught us a lot about what makes a great book. Additionally, Meredith Gertz, our content producer, helped us develop new technology—
videos and animations—for this edition. She also guided us through the writing and
production processes, helping to keep us on schedule while maintaining extremely
high quality. Our thanks also go to Kim Fletcher of Integra Software Services Inc., who
served as the project manager and did a superb job keeping us on task. Kerri Tomasso
also assisted in the overall project management on this edition. Miguel Leonarte, who
helped develop MyLab Finance, also deserves a word of thanks for making MyLab
Finance flow so seamlessly with the book. He has continued to refine and improve
MyLab Finance, and as a result of his efforts, it has become a learning tool without
equal. We also thank Melissa Honig, our digital studio producer, who did a great job
of making sure we are on the cutting edge in terms of Web applications 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.
xxix
1
CHAPTER
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 different legal forms
of business organization.
The Legal Forms of Business
Organization
LO5
Explain what has led to the era of the multinational
corporation.
Finance and the Multinational
Firm: The New Role
LO6
Describe how this course and the skills you will
develop in it will help you in your career and in
your life.
Developing Skills for Your Career
A
pple 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, Apple stock was selling for 50 cents per
share and 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,
22 years later, in 2018, the price of Apple’s common stock was up to $180 per share,
climbing about 360 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.
2
Between the introduction of the iPod in
October 2001 and the beginning 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 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 and
revising your products, and you keep
developing and introducing new products that consumers want—the iPhone. With this in mind, in September 2017, Apple
unveiled its iPhone 8 and iPhone X, which immediately dominated smart phone
sales, accounting for 61 percent of smartphone sales in the fourth quarter of 2017.
In effect, Apple seems to have a never-ending supply of new, exciting products that
we all want. In 2014 Apple bought Beats for $3 billion; then in April 2015, Apple introduced the Apple Watch; and while there have been rumors about introducing an
Apple Car in 2020s, it now looks like Apple is gearing up to release an augmented reality headset in the near future. Through all of this, Apple has developed and expanded
its services including Apple Pay, Apple Music, the iTunes Store, and iCloud to the point
where, in 2018, these new services account for about 16 percent of their total revenue.
How did Apple make the decision to introduce the original iPod and then 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 creating 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 borrow 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 management 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
LO1
Identify 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 shareholders by making decisions that will maximize the price of the existing common stock.
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PART 1 • The Scope and Environment of Financial Management
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 decisions 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.
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. Attempting to identify a reaction to a particular financial decision would simply be impossible, and fortunately, 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 discussions, 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?
the basic
LO2 Understand
principles of finance,
their importance, and the
importance of ethics and trust.
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 principles 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
stockholders).
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 techniques presented in this text, and thereby allowing us to focus …
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