Intermediate Financial Management - GBV

Intermediate
Financial

Management

TENTH EDITION

Eugene F. Brigham

University of Florida

Phillip R. Daves

University of Tennessee

/ c> SOUTH-WESTERN

t c? CENGAGE Learning'

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

CONTENTS

Preface iv The CAPM, Risk, and Return: Is Something
Missing? 61
PART1
Fundamental Concepts Summary 62
of Corporate Finance i
Chapter 3
Chapter 1 Risk and Return: Part II 72
An Overview of Financial Management 2
Beginning-of-Chapter Questions 73
Beginning-of-Chapter Questions 3 Box: Corporate Valuation and Risk 73
About Using the Text 3 Efficient Portfolios 74
The Primary Objective of the Corporation: Value Choosing the Optimal Portfolio 78
The Basic Assumptions of the Capital Asset
Maximization 4
Box: Ethics for Individuals and Businesses 6 Pricing Model 81
Box: Corporate Scandals and Maximizing The Capital Market Line and the Security

Stock Price 8 Market Line 82
Agency Relationships 9 Calculating Beta Coefficients 86
Transparency in Financial Reporting 15 Empirical Tests of the CAPM 93
Financial Securities and the Cost of Money 18 Arbitrage Pricing Theory 96
A Preview of What's Ahead 22 The Fama-French Three-Factor Model 99
e-Resources 23 An Alternative Theory of Risk and Return:
Summary 24
Behavioral Finance 102
Chapter 2 Summary 104
Risk and Return: Part 28
Chapter 4
Beginning-of-Chapter Questions 29 Bond Valuation n o
Investment Returns 29
Box: Corporate Valuation and Risk 30 Beginning-of-Chapter Questions 111
Stand-Alone Risk 31 Box: Corporate Valuation and Risk 111
Box: The Trade-Off between Risk Who Issues Bonds? 112
Key Characteristics of Bonds 113
and Return 39 Bond Valuation 117
Risk in a Portfolio Context 41 Bond Yields 121
Box: The Benefits of Diversifying Overseas 48 Changes in Bond Values over Time 124
Calculating Beta Coefficients 53 Box: Drinking Your Coupons 127
The Relationship between Risk and Rates Bonds with Semiannual Coupons 127
The Determinants of Market Interest Rates 128
of Return 56 The Real Risk-Free Rate of Interest, r* 130

XXI

xxii « Contents Box: Taxes and Stock Options 207
The Valuation of Put Options 208
The Inflation Premium (IP) 130 Applications of Option Pricing in Corporate
The Nominal, or Quoted, Risk-Free
Finance 209
Rate of Interest, rRF 132 Summary 211
The Default Risk Premium (DRP) 133
The Liquidity Premium (LP) 138 Chapter 7
The Maturity Risk Premium (MRP) 139 Accounting for Financial Management 215
The Term Structure of Interest Rates 142
Junk Bonds 144 Beginning-of-Chapter Questions 216
Bankruptcy and Reorganization 145 Box: Corporate Valuation and Financial
Summary 146
Statements 216
Chapter 5 Financial Statements and Reports 217
Basic Stock Valuation 154 The Balance Sheet 217
The Income Statement 218
Beginning-of-Chapter Questions 155 Statement of Retained Earnings 220
Box: Corporate Valuation and Stock Risk 155 Net Cash Flow 221
Legal Rights and Privileges of Common Box: Financial Analysis on the Internet 222
Statement of Cash Flows 223
Stockholders 156 Modifying Accounting Data for Managerial
Types of Common Stock 157
Stock Market Reporting 158 Decisions 226
Common Stock Valuation 159 Box: Financial Bamboozling: How to Spot It 230
Constant Growth Stocks 162 MVA and EVA 234
Expected Rate of Return on a Constant Box: Sarbanes-Oxley and Financial Fraud 237
The Federal Income Tax System 238
Growth Stock 166 Summary 243
Valuing Stocks That Have a Nonconstant
Chapter 8
Growth Rate 168
Stock Valuation by the Free Cash Flow Analysis of Financial Statements 254

Approach 171 Beginning-of-Chapter Questions 255
Market Multiple Analysis 172 Box: Corporate Valuation and Analysis of Financial
Preferred Stock 173
Stock Market Equilibrium 1 74 Statements 255
The Efficient Markets Hypothesis 117 Financial Analysis 256
Summary 180 Liquidity Ratios 256
Asset Management Ratios 259
Chapter 6 Debt Management Ratios 262
Financial Options 190 Profitability Ratios 265
Box: International Accounting Differences Create
Beginning-of-Chapter Questions 191
Financial Options 191 Headaches for Investors 266
Box: Financial Reporting for Employee Market Value Ratios 268
Trend Analysis, Common Size Analysis,
Stock Options 197
Introduction to Option Pricing Models: The and Percentage Change Analysis 271
Tying the Ratios Together: The Du Pont
Binomial Approach 197
The Black-Scholes Option Pricing Model Equation 274

(OPM) 203

Contents ° xxiii

Comparative Ratios and Benchmarking 276 Composite, or Weighted Average, Cost of Capital,
Uses and Limitations of Ratio Analysis 277 WACC 343
Box: Ratio Analysis in the Web 278
Looking beyond the Numbers 279 Box: Global Variations in the Cost of Capital 345
Summary 280 Factors that Affect the Weighted Average Cost '

PART 2 of Capital 346
Corporate Valuation 291
Adjusting the Cost of Capital for Risk 347
Chapter 9 Privately Owned Firms and Small Businesses 350
Financial Planning and Forecasting Four Mistakes to Avoid 351
Summary 352
Financial Statements 292
Chapter 11
Beginning-of-Chapter Questions 293 Corporate Valuation and Value-Based

Box: Corporate Valuation and Financial Management 363

Planning 293 Beginning-of-Chapter Questions 364
Box: Corporate Valuation: Putting
Overview of Financial Planning 294
the Pieces Together 364
Sales Forecast 295 Overview of Corporate Valuation 365
The Corporate Valuation Model 366
The Additional Funds Needed (AFN) Value-Based Management 374
Box: Value-Based Management in Practice 383
Formula 297 Managerial Behavior and Shareholder

Forecasted Financial Statement (FFS) Method 300 Wealth 384
Corporate Governance 385
Forecasting Financial Requirements Box: The Sarbanes-Oxley Act of 2002

When the Balance Sheet Ratios Are and Corporate Governance 392
Box: International Corporate Governance 394
Subject to Change 311 Employee Stock Ownership Plans (ESOPs) 396
Summary 399
Summary 315 /
PART 3
Chapter 10 Project Valuation 409
Determining the Cost of Capital 324
Chapter 12
Beginning-of-Chapter Questions 325 Capital Budgeting: Decision Criteria 41 o
Box: Corporate Valuation and the Cost
Beginning-of-Chapter Questions 411
of Capital 325 Box: Corporate Valuation and Capital
The Weighted Average Cost of Capital 326
Cost of Debt, rd(1 - T) 326 Budgeting 411
Cost of Preferred Stock, rps 329 Overview of Capital Budgeting 412
Cost of Common Stock, rs 330 Net Present Value (NPV) 413
The CAPM Approach 331 Internal Rate of Return (IRR) 415
Dividend-Yield-Plus-Growth-Rate, or Discounted Comparison of the NPV and IRR Methods 41 7
Multiple IRRs 420
Cash Flow (DCF), Approach 337
Bond-Yield-Plus-Risk-Premium Approach 340
Comparison of the CAPM, DCF, and

Bond-Yield-Plus-Risk-Premium Methods 340
Adjusting the Cost of Stock for Flotation

Costs 341

xxiv Contents

Modified Internal Rate of Return (MIRR) 422 Strategic Financing Decisions 515
Profitability Index 424
Payback Methods 425 Chapter 15
Conclusions on Capital Budgeting Capital Structure Decisions: Part I 516

Methods 428 Beginning-of-Chapter Questions 517
Business Practices 430 Box: Corporate Valuation and Capital
Special Applications of Cash Flow
Structure 517
Evaluation 431 A Preview of Capital Structure Issues 518
The Optimal Capital Budget 434 Business Risk and Financial Risk 520
Summary 436 Capital Structure Theory 526
Box: Yogi Berra on the MM Proposition 528
Chapter 13 Capital Structure Evidence and Implications 535
Capital Budgeting: Estimating Cash Flows Box: Taking a Look at Global Capital

and Analyzing Risk 447 Structures 537
Estimating the Optimal Capital Structure 538
Beginning-of-Chapter Questions 448 Summary 550
Box: Corporate Valuation, Cash Flows,
Chapter 1 6
and Risk Analysis 448 Capital Structure Decisions: Part II 559
Estimating Cash Flows 448
Project Analysis: An Example 450 Beginning-of-Chapter Questions 560
Issues in Project Analysis 456 Box: Corporate Valuation and Capital Structure
Depreciation 459
Adjusting for Inflation 462 Decisions 560
Project Risk Analysis: Techniques for Measuring Capital Structure Theory: Arbitrage Proofs of the

Stand-Alone Risk 463 Modigliani-Miller Models 560
Box: Capital Budgeting Practices in the Asia/Pacific Introducing Personal Taxes: The Miller Model 571
Criticisms of the MM and Miller Models 574
Region 469 An Extension to the MM Model: Nonzero Growth
Project Risk Conclusions 473
Incorporating Project Risk into Capital and a Risky Tax Shield 576
Risky Debt and Equity as an Option 580
Budgeting 474 Capital Structure Theory: Our View 584 <
Managing Risk Through Phased Decisions: Summary 586

Decision Trees 475
Introduction to Real Options 477
Summary 479

Chapter 14 Chapter 1 7
Real Options 489 Distributions to Shareholders: Dividends

Beginning-of-Chapter Questions 490 and Repurchases 592
Valuing Real Options 490
The Investment Timing Option: Beginning-of-Chapter Questions 593
An Overview of Cash Distributions 593
An Illustration 491 Procedures for Cash Distributions 595
The Growth Option: An Illustration 501 Cash Distributions and Firm Value 598
Box: Growth Options at Dot-Corn Companies 504 Clientele Effect 600
Concluding Thoughts on Real Options 507 Information Content, or Signaling, Hypothesis 601
Summary 509 Implications for Dividend Stability 603

Contents

Setting the Target Distribution Level: The Residual Financial Statement Effects 672
Distribution Model 603 Evaluation by the Lessee 674
Evaluation by the Lessor 679
Application of the Residual Dividend Model 606 Box: What You Don't Know Can Hurt You! 682
Distributions Through Stock Repurchases 607 Other Issues in Lease Analysis 682
Comparison of Dividends and Repurchases 610 Box: Lease Securitization 685
Box: Dividend Yields around the World 612 Other Reasons for Leasing 686
Other Factors Influencing Distributions 612 Summary 687
Summarizing the Distribution Policy Decision 614
Stock Splits and Stock Dividends 615 Chapter 20
Dividend Reinvestment Plans 618 Hybrid Financing: Preferred Stock,
Summary 619
Warrants, and Convertibles 694

PARTS Beginning-of-Chapter Questions 695
Tactical Financing Decisions 627 Preferred Stock 695
Box: Where's the Dividend? 697
Chapter 18 Box: MIPS, QUIPS, TOPrS, and QUIDS:
Initial Public Offerings, Investment
A Tale of Two Perspectives 698
Banking, and Financial Restructuring 628 Warrants 700
Convertible Securities 707
Beginning-of-Chapter Questions 629 A Final Comparison of Warrants
Box: Corporate Valuation, IPOs, and Financial
and Convertibles 715
Restructuring 629 Reporting Earnings when Warrants or Convertibles
The Financial Life Cycle of a Start-Up
Are Outstanding 716
Company 630 Summary 717
The Decision to Go Public 631
The Process of Going Public: An Initial Public PART 6
Working Capital Management 725
Offering 633
Equity Carve-Outs: A Special Type of IPO 641 Chapter 21
Non-IPO Investment Banking Activities 642 Working Capital Management 726
The Decision to Go Private 646
Managing the Maturity Structure of Debt 648 Beginning-of-Chapter Questions 727
Refunding Operations 650 Box: Corporate Valuation and Working Capital
Box: TVA Ratchets Down Its Interest
Management 727
Expenses 655 The Cash Conversion Cycle 728
Managing the Risk Structure of Debt 657 Alternative Net Operating Working Capital
Box: Bowie Bonds Ch-Ch-Change Asset
Policies 732
Securitization 660 Cash Management 733
Summary 661 The Cash Budget 734
Box: The CFO Cash Management Scorecard 738
Chapter 19 Cash Management Techniques 738
Lease Financing 667 Inventory 740
Box: Supply Chain Management 741
Beginning-of-Chapter Questions 668 Receivables Management 742
Types of Leases 668 Box: Supply Chain Finance 744
Tax Effects 671

xxvi ° Contents

Accruals and Accounts Payable (Trade Credit) 747 PART 7
Alternative Short-Term Financing Policies 750 Special Topics 833
Short-Term Investments: Marketable
Chapter 24
Securities 752 Derivatives and Risk Management 834
Short-Term Financing 753
Short-Term Bank Loans 754 Beginning-of-Chapter Questions 835
Commercial Paper 756 Box: Corporate Valuation and Risk
Use of Security in Short-Term Financing 757
Summary 758 Management 835
Reasons to Manage Risk 835
Chapter 22 Background on Derivatives 838
Providing and Obtaining Credit 769 Derivatives in the News 839
Other Types of Derivatives 843
Beginning-of-Chapter Questions 770 Corporate Risk Management 850
Box: Corporate Valuation and Credit Box: Microsoft's Goal: Manage Every Risk! 852
Using Derivatives to Reduce Risks 853
Policy 770 Box: Risk Management in the Cyber Economy 857
Credit Policy 771 Summary 861
Setting the Credit Period and Standards 771
Setting the Collection Policy 772 Chapter 25
Cash Discounts 773 Bankruptcy, Reorganization,
Other Factors Influencing Credit Policy 773
The Payments Pattern Approach to Monitoring and Liquidation 865

Receivables 774 Beginning-of-Chapter Questions 866
Analyzing Proposed Changes in Credit Financial Distress and Its Consequences 866
Issues Facing a Firm in Financial Distress 868
Policy 778 Settlements without Going through Formal
Analyzing Proposed Changes in Credit Policy:
Bankruptcy 869
Incremental Analysis 781 Federal Bankruptcy Law 871
The Cost of Bank Loans 787 Reorganization in Bankruptcy 872
Choosing a Bank 794 Liquidation in Bankruptcy 882
Summary 796 Other Motivations for Bankruptcy 885
Some Criticisms of Bankruptcy Laws 886
Chapter 23 Other Topics in Bankruptcy 887
Other Topics in Working Capital Summary 887

Management 805 Chapter 26
Mergers, LBOs, Divestitures, and
Beginning-of-Chapter Questions 806
Box: Corporate Valuation and Working Capital Holding Companies 894

Management 806 Beginning-of-Chapter Questions 895
The Concept of Zero Working Capital 806 Rationale for Mergers 896
Setting the Target Cash Balance 807 Types of Mergers 899
Inventory Control Systems 813 Level of Merger Activity 899
Accounting for Inventory 815 Hostile versus Friendly Takeovers 901
The Economic Ordering Quantity (EOQ) Merger Regulation 902

Model 817
EOQ Model Extensions 823
Summary 828

Contents ° xxvii

Overview of Merger Analysis 904 Appendixes
The Adjusted Present Value (APV) Approach 905 Appendix A Values of the Areas under
The Free Cash Flow to Equity (FCFE) Approach 908
Illustration of the Three Valuation Approaches the Standard Normal Distribution
Function 983
for a Constant Capital Structure 910 Appendix B Answers to End-of-Chapter
Setting the Bid Price 915 Problems 984
Analysis When There Is a Permanent Change Appendix C Selected Equations
and Data 992
in Capital Structure 916
Taxes and the Structure of the Takeover Bid 918 Glossary 1005
Box: Tempest in a Teapot? 920 Name Index 1021
Financial Reporting for Mergers 922 Subject Index 1025
Analysis for a "True Consolidation" 925
The Role of Investment Bankers 926 Web Chapters
Who Wins: The Empirical Evidence 929 Chapter 28 Time Value of Money
Box: Merger Mistakes 930 Chapter 29 Basic Financial Tools: A Review
Corporate Alliances 930 Chapter 30 Pension Plan Management
Leveraged Buyouts 931 Chapter 31 Financial Management
Divestitures 933
Holding Companies 934 in Not-for-Profit Businesses
Summary 936
Web Extensions
Chapter 27 Web Extension 1-A A Closer Look at
Multinational Financial Management 943
Markets: Securitization and Social
Beginning-of-Chapter Questions 944 Welfare
Multinational, or Global, Corporations 944 Web Extension 1-B An Overview of
Multinational versus Domestic Financial Derivatives
Web Extension 1-C A Closer Look at the
Management 946 Stock Markets
Exchange Rates 947 Web Extension 2-A Continuous
Exchange Rates and International Trade 951 Probability Distributions
The International Monetary System and Exchange Web Extension 2-B Estimating Beta with a
Financial Calculator
Rate Policies 952
Trading in Foreign Exchange 956 No Web Extension for Chapter 3
Interest Rate Parity 958
Purchasing Power Parity 960 Web Extension 4-A A Closer Look at Zero
Box: Hungry for a Big Mac? Go to Malaysia! 961 Coupon Bonds
Inflation, Interest Rates, and Exchange Rates 963
International Money and Capital Markets 964 Web Extension 4-B A Closer Look at TIPS:
Box: Greasing the Wheels of International Treasury Inflation-Protected Securities

Business 965 Web Extension 4-C Bond Risk and
Box: Stock Market Indices around Duration

the World 967
Multinational Capital Budgeting 968
International Capital Structures 972
Multinational Working Capital Management 973
Summary 977

xxviii ° Contents

Web Extension 4-D The Pure Expectations Web Extension 18-A Rights Offerings
Theory and Estimation of Forward Rates Web Extension 19-A Percentage Cost

Web Extension 5-A Derivation of Valuation Analysis
Equations
Web Extension 19-B Leasing Feedback
Web Extension 6-A The Binomial Approach Web Extension 19-C Leveraged Leases
Web Extension 7-A The Federal Income Web Extension 20-A Calling Convertible

Tax System for Individuals Issues
Web Extension 21-A Secured Short-Term
No Web Extension for Chapter 8
Financing
Web Extension 9-A Financing Feedbacks
Web Extension 9-B Advanced Techniques No Web Extension for Chapter 22
No Web Extension for Chapter 23
for Forecasting Financial Statements
Accounts Web Extension 24-A Risk Management
Web Extension 10-A Estimating Growth with Insurance
Rates
Web Extension 10-B The Cost of Equity Web Extension 25-A Anatomies of Two
in the Nonconstant Dividend Growth Business Failures
Model
Web Extension 25-B Multiple Discriminant
No Web Extension for Chapter 11 Analysis

Web Extension 12-A The Accounting Rate Web Extension 26-A Projecting Consistent
of Return (ARR) Debt and Interest Expenses

Web Extension 12-B The Marginal Cost of No Web Extension for Chapter 27
Capital and the Optimal Capital Budget
Web Extension 28-A Derivation of Annuity
Web Extension 13-A Replacement Project Formulas
Analysis
Web Extension 28-B Continuous
Web Extension 13-B Certainty Equivalents Compounding
and Risk-Adjusted Discount Rates
Web Extension 28-C The Tabular
Web Extension 14-A The Abandonment Approach
Real Option
WEB NOTES
Web Extension 14-B Risk-Neutral Valuation Be sure to visit the Intermediate Financial
Web Extension 15-A Degree of Leverage Management Web site at www.cengage
.com/finance/brigham for more
No Web Extension for Chapter 16 information about this text.
No Web Extension for Chapter 17