Parrino

SECOND
EDITION

FUNDAMENTALS OF

CORPORATE

FINANCE

Robert Parrino

Lamar Savings Centennial Professor of Finance
University of Texas at Austin

David S. Kidwell

Professor of Finance and Dean Emeritus
University of Minnesota

Thomas W. Bates

Department Chair and Associate Professor of Finance
Arizona State University

John Wiley & Sons, Inc.

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SECOND
EDITION

FUNDAMENTALS OF

CORPORATE

FINANCE

Robert Parrino

Lamar Savings Centennial Professor of Finance
University of Texas at Austin

David S. Kidwell

Professor of Finance and Dean Emeritus
University of Minnesota

Thomas W. Bates

Department Chair and Associate Professor of Finance
Arizona State University

John Wiley & Sons, Inc.

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ISBN: 978-0-470-87644-2
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Dedication

ROBERT PARRINO
To my parents, whose life-long support and commitment to education
inspired me to become an educator and to my wife, Emily, for her
unending support.

DAVID KIDWELL
To my parents, Dr. William and Margaret Kidwell for their endless
support of my endeavors, to my son, David Jr., of whom I am very
proud, and to my wife Jillinda who is the joy of my life.

THOMAS BATES
To my wife, Emi, and our daughters Abigail and Lillian. Your support,
patience, fun, and friendship make me a better educator, scholar, and
person.

ABOUT THE AUTHORS ROBERT PARRINO

Lamar Savings Centennial Professor of Finance
McCombs School of Business, University of Texas at Austin

A member of the faculty at University of Texas since 1992, Dr. Parrino teaches courses in
regular degree and executive education programs at the University of Texas, as well as in
customized executive education courses for industrial, financial, and professional firms. He
has also taught at the University of Chicago, University of Rochester, and IMADEC University
in Vienna. Dr. Parrino has received numerous awards for teaching excellence at University
of Texas from students, faculty, and the Texas Ex’s (alumni association).

Dr. Parrino has been involved in advancing financial education outside of the classroom
in a variety of ways. As a Chartered Financial Analyst (CFA) charterholder he has been
very active with the CFA Institute, having been a member of the candidate curriculum
committee, served as a regular speaker at the annual Financial Analysts Seminar, spoken at
over 20 Financial Analyst Society meetings, and as a past member of the planning committee
for the CFA Institute’s Annual Meeting. In addition, Dr. Parrino is the founding director of
the Hicks, Muse, Tate & Furst Center for Private Equity Finance at the University of Texas.
Dr. Parrino was Vice President for Financial Education of the Financial Management
Association (FMA) from 2008 to 2010 and has been elected to serve as an academic director
of the FMA from 2011 to 2013.

Dr. Parrino is also co-founder of the Financial Research Association and is Associate Editor
of the Journal of Corporate Finance and the Journal of Financial Research. Dr. Parrino’s
research includes work on corporate governance, financial policies, restructuring, and
mergers and acquisitions, as well as research on private equity markets. He has published his
research in a number of journals, including the Journal of Finance, Journal of Financial
Economics, Journal of Financial and Quantitative Analysis, Journal of Law and Economics,
Journal of Portfolio Management, and Financial Management. Dr. Parrino has won a number
of awards for his research.

Dr. Parrino has experience in the application of corporate finance concepts in a variety of
business situations. Since entering the academic profession he has been retained as an
advisor on valuation issues concerning businesses with enterprise values ranging to more
than $1 billion and has consulted in areas such as corporate financing, compensation, and
corporate governance. Dr. Parrino is currently on the advisory council of Virgo capital, a
private equity firm, and was previously President of Sprigg Lane Financial, Inc., a financial
consulting firm with offices in Charlottesville, Virginia and New York City. While at Sprigg
Lane, he was on the executive, banking, and portfolio committees of the holding company
that owns Sprigg Lane. Before joining Sprigg Lane, Dr. Parrino was on the Corporate
Business Planning and Development staff at Marriott Corporation. At Marriott, he con-
ducted fundamental business analyses and preliminary financial valuations of new business
development opportunities and potential acquisitions. Dr. Parrino holds a B.S. in chemical
engineering from Lehigh University, an MBA degree from The College of William and
Mary, and M.S. and Ph.D. degrees in applied economics and finance, respectively, from
University of Rochester.

DAVID S. KIDWELL THOMAS W. BATES

Professor of Finance and Dean Emeritus Department Chair and Associate Professor of Finance

Curtis L. Carlson School of Management, University of Minnesota W. P. Carey School of Business, Arizona State University

Dr. Kidwell has over 30 years experience in financial Dr. Bates is the Chair of the Department of Finance and
education, as a teacher, researcher, and administrator. He Dean’s Council of 100 Distinguished Scholar at the
has served as Dean of the Carlson School at the University W. P. Carey School of Business, Arizona State University.
of Minnesota and of the School of Business Administration He has also taught courses in finance at the University of
at the University of Connecticut. Prior to joining the Delaware, the Ivey School of Business at the University of
University of Connecticut, Dr. Kidwell held endowed chairs Western Ontario, and the University of Arizona where he
in banking and finance at Tulane University, the University received the Scrivner teaching award. During his career as
of Tennessee, and Texas Tech University. He was also on the an educator, Professor Bates has taught corporate finance
faculty at the Krannert Graduate School of Management, to students in undergraduate, MBA, executive MBA, and
Purdue University where he was twice voted the outstanding Ph.D. programs, as well as in custom corporate educa-
undergraduate teacher of the year. tional courses.

An expert on the U.S. financial system, Dr. Kidwell is the Professor Bates is a regular contributor to the academic
author of more than 80 articles dealing with the U.S. finance literature in such journals as The Journal of Finance,
financial system and capital markets. He has published his Journal of Financial Economics, and Financial Management.
research in the leading journals, including Journal of His research addresses a variety of issues in corporate
Finance, Journal of Financial Economics, Journal of Financial finance including the contracting environment in mergers
and Quantitative Analysis, Financial Management, and and acquisitions, corporate liquidity decisions and cash
Journal of Money, Credit, and Banking. Dr. Kidwell has also holdings, and the governance of corporations. In practice,
participated in a number of research grants funded by the Dr. Bates has worked with companies and legal firms as an
National Science Foundation to study the efficiency of U.S. advisor on issues related to the valuation of companies and
capital markets, and to study the impact of government corporate governance. Dr. Bates received a B.A. in Econom-
regulations upon the delivery of consumer financial services. ics from Guilford College and his doctorate in finance from
the University of Pittsburgh.
Dr. Kidwell has been a management consultant for Coopers &
Lybrand and a sales engineer for Bethlehem Steel Corporation.
He currently serves on the Board of Directors and is the
Chairman of the Audit and Risk Committee of the Schwan
Food Company. Dr. Kidwell is the past Secretary-Treasurer of
the Board of Directors of AACSB, the International Association
for Management Education and is a past member of the Boards
of the Minnesota Council for Quality, the Stonier Graduate
School of Banking, and Minnesota Center for Corporate
Responsibility. Dr. Kidwell has also served as an Examiner for
the 1995 Malcolm Baldrige National Quality Award, on the
Board of Directors of the Juran Center for Leadership in Quality,
and on the Board of the Minnesota Life Insurance Company.

Dr. Kidwell holds an undergraduate degree in mechanical
engineering from California State University at San Diego,
an MBA with a concentration in finance from California
State University at San Francisco, and a Ph.D. in finance
from the University of Oregon.

Preface

We have written Fundamentals of Corporate Finance for use in an introductory course in
corporate finance at the undergraduate level. It is also suitable for advanced undergradu-
ate, executive development, and traditional or executive MBA courses when supple-
mented with cases and outside readings. The main chapters in the book assume that
students are well-versed in algebra and that they have taken courses in principles of
economics and financial accounting. Optional chapters covering important economic
and financial accounting concepts are included for students and instructors seeking
such coverage.

Balance Between Conceptual Understanding
and Computational Skills

We wrote this corporate finance text for one very important reason. We want to provide stu-
dents and instructors with a book that strikes the best possible balance between helping stu-
dents develop an intuitive understanding of key financial concepts and providing them with
problem-solving and decision-making skills. In our experience, teaching students at all levels
and across a range of business schools, we have found that students who understand the intu-
ition underlying the basic concepts of finance are better able to develop the critical judgment
necessary to apply financial tools to a broad range of real-world situations. An introductory
corporate finance course should provide students with a strong understanding of both the
concepts and tools that will help them in their subsequent business studies and their personal
and professional lives.

Market research supports our view. Many faculty members who teach the introductory
corporate finance course to undergraduates express a desire for a book that bridges the gap
between conceptually-focused and computationally-focused books. This text is designed to
bridge this gap. Specifically, the text develops the fundamental concepts underlying corporate
finance in an intuitive manner while maintaining a strong emphasis on developing computa-
tional skills. It also takes the students one step further by emphasizing the use of intuition and
analytical skills in decision making.

Our ultimate goal has been to write a book and develop associated learning tools that
help our colleagues succeed in the classroom—materials that are genuinely helpful in the
learning process. Our book offers a level of rigor that is appropriate for finance majors and yet
presents the content in a manner that both finance and non-finance students find accessible
and want to read. Writing a book that is both rigorous and accessible has been one of our key
objectives, and both faculty and student reviews of the first edition, as well as pre-publication
chapters from this second edition, suggest that we have achieved this objective.

We have also tried to provide solutions to many of the challenges facing finance faculty in
the current environment, who are asked to teach ever-increasing numbers of students with
limited resources. Faculty members need a book and associated learning tools that help them
effectively leverage their time. The organization of this book and the supplemental materials,
along with the innovative WileyPLUS Web-based interface, which offers extensive problem
solving opportunities and other resources for students, provide such leverage to an extent not
found with other textbooks.

PREFACE ix

A Focus on Value Creation

This book is more than a collection of ideas, equations, and chapters. It has an important in-
tegrating theme—that of value creation. This theme, which is carried throughout the book,
provides a framework that helps students understand the relations between the various con-
cepts covered in the book and makes it easier for them to learn these concepts.

The concept of value creation is the most fundamental notion in corporate finance. It is
in stockholders’ best interests for value maximization to be at the heart of the financial deci-
sions made within the firm. Thus, it is critical that students be able to analyze and make
business decisions with a focus on value creation. The concept of value creation is intro-
duced in the first chapter of the book and is further developed and applied throughout the
remaining chapters.

The theme of value creation is operationalized through the net present value (NPV)
concept. Once students grasp the fundamental idea that financial decision makers should
only choose courses of action whose benefits exceed their costs, analysis and decision mak-
ing using the NPV concept becomes second nature. By helping students better understand
the economic rationale for a decision from the outset, rather than initially focusing on com-
putational skills, our text keeps students focused on the true purpose of the calculations and
the decision at hand.

Integrated Approach: Intuition, Analysis, and Decision Making

To support the focus on value creation, we have emphasized three things: (1) providing an
intuitive framework for understanding fundamental finance concepts, (2) teaching students
how to analyze and solve finance problems, and (3) helping students develop the ability to use
the results from their analyses to make good financial decisions.

1. An Intuitive Approach: We believe that explaining finance concepts in an intuitive
context helps students develop a richer understanding of those concepts and gain better
insights into how finance problems can be approached. It is our experience that students
who have a strong conceptual understanding of financial theory better understand how
things really work and are better problem solvers and decision makers than students
who focus primarily on computational skills.

2. Analysis and Problem Solving: With a strong understanding of the basic principles of
finance, students are equipped to tackle a wide range of financial problems. In addition
to the many numerical examples that are solved in the text of each chapter, this book has
almost 1,200 end-of-chapter homework and review problems that have been written
with Bloom’s Taxonomy in mind. Solutions for these problems are provided in the
Instructor’s Manual. We strive to help students acquire the ability to analyze and solve
finance problems.

3. Decision Making: In the end, we want to prepare students to make sound financial
decisions. To help students develop these skills, throughout the text we illustrate how the
results from financial analyses are used in decision making.

Organization and Coverage

n order to help students develop the skills necessary to tackle knowledge and tools that students should understand before
nvestment and financing decisions, we have arranged the they begin the study of financial concepts. Most of the mate-
book’s 21 chapters into five major building blocks, that collec- rial in these chapters is typically taught in other courses.
ively comprise the seven parts of the book, as illustrated in the Since students come to the corporate finance course with
ccompanying exhibit and described below. varying academic backgrounds, and because the time that
has elapsed since students have taken particular prerequisite
ntroduction courses also varies, the chapters in Part 2 can help the in-
structor ensure that all students have the same base level of
Part 1, which consists of Chapter 1, provides an introduction knowledge early in the course. Depending on the educational
o corporate finance. It describes the role of the financial man- background of the students, the instructor might not find it
ger, the types of fundamental decisions that financial mangers necessary to cover all or any of the material in these chapters.
make, alternative forms of business organization, the goal of Some or all of these chapters might, instead, be assigned as
he firm, agency conflicts and how they arise, and the impor- supplemental readings.
ance of ethics in financial decision-making. These discussions
et the stage and provide a framework that students can use to Chapter 2 describes the services financial institutions pro-
hink about key concepts as the course progresses. vide to businesses, how domestic and international financial
markets work, the concept of market efficiency, how firms use
Foundations financial markets, and how interest rates are determined in the
economy. Chapter 3 describes the key financial statements and
Part 2 of the text consists of Chapters 2 through 4. These chap- how they are related, as well as how these statements are related
ers present the basic institutional, economic, and accounting to cash flows to investors. Chapter 4 discusses ratio analysis

Introduction Basic Concepts Analysis Integration
&
Part 4: Capital Budgeting Decisions Part 6: Business Formation,
Tools Chapter 10. The Fundamentals of Valuation, and Financial
Planning
Part 1: Introduction Part 3: Valuation of Future Cash Flows Capital Budgeting
Chapter 5. The Time Value of Money Chapter 11. Cash Flows and Capital Chapter 18. Business Formation,
Chapter 1. The Financial Chapter 6. Discounted Cash Flows and Growth, and Valuation
Manager and Budgeting
the Firm Valuation Chapter 12. Evaluating Project Chapter 19. Financial Planning and
Chapter 7 Risk and Return Forecasting
Chapter 8. Bond Valuation and the Economics and Capital
Rationing Part 7: Options in Corporate
Structure of Interest Rates Chapter 13. The Cost of Capital Finance and International
Chapter 9. Stock Valuation Decisions
Part 5: Working Capital Management
and Financing Decisions Chapter 20. Options and Corporate
Finance
Chapter 14. Working Capital
Management Chapter 21. International Financial
Management
Chapter 15. How Firms Raise Capital
Part 2: Foundations Chapter 16. Capital Structure Policy
Chapter 2. The Financial System and the Level of Interest Rates Chapter 17. Dividends, Stock
Chapter 3. Financial Statements, Cash Flows, and Taxes
Chapter 4. Analyzing Financial Statements Repurchases, and Payout
Policy

ORGANIZATION AND COVERAGE xi

and other tools used to evaluate financial statements. Through- decisions with an introduction to dividends, stock repurchases,
out Part 2, we emphasize the importance of cash flows to get stock dividends and splits, and payout policy.
students thinking about cash flows as a critical component of
all valuation calculations and financial decisions. Integration

Basic Concepts and Tools Part 6, which consists of Chapters 18 and 19, brings together many
of the key concepts introduced in the earlier parts of the text.
Part 3 presents basic financial concepts and tools and illus- Chapter 18 covers financial aspects of business formation and
trates their application. This part of the text, which consists of growth and introduces students to business valuation concepts
Chapters 5 through 9, introduces time value of money and risk for both private and public firms. The discussions in this chapter
and return concepts and then applies present value concepts to integrate the investment and financing concepts discussed in
bond and stock valuation. These chapters provide students Parts 4 and 5 to provide students with a more complete picture
with basic financial intuitions and computational tools that of how all the financial concepts fit together. Chapter 19 covers
will serve as the building blocks for analyzing investment and concepts related to financial planning and forecasting.
financing decisions in subsequent chapters.
Part 7 introduces students to some important issues that
Analysis managers must deal with in applying the concepts covered in
the text to real-world problems. Chapter 20 introduces call
Parts 4 and 5 of the text focus on investment and financing and put options and discusses how they relate to investment
decisions. Part 4 covers capital budgeting. Chapter 10 intro- and financing decisions. It describes options that are embed-
duces the concept of net present value and illustrates its appli- ded in the securities that firms issue. It also explains, at an
cation as the principle tool for evaluating capital projects. It accessible level, the idea behind real options and why tradi-
also discusses alternative capital budgeting decision rules, such tional NPV analysis does not take such options into account.
as internal rate of return, payback period, and accounting rate In addition, the chapter discusses agency costs of debt and
of return, and compares them with the net present value crite- equity and the implications of these costs for investment and
rion. This discussion provides a framework that will help stu- financing decisions. Finally, Chapter 20 illustrates the use of
dents in the rest of Part 4 as they learn the nuances of capital options in risk management. Instructors can cover the topics
budgeting analysis in realistic settings. in Chapter 20 near the end of the course or insert them at the
appropriate points in Parts 4 and 5. Chapter 21 examines how
Chapters 11 and 12 follow with in-depth discussions of how international considerations affect the application of concepts
cash flows are calculated and forecast. The cash flow calculations covered in the book.
are presented in Chapter 11 using a valuation framework that
will help students think about valuation concepts in an intuitive Unique Chapters
way and will prepare them for the extension of these concepts to
business valuation in Chapter 18. Chapter 12 covers analytical Chapter on Business Formation, Growth,
tools—such as breakeven, sensitivity, scenario, and simulation and Valuation
analysis—that will give students a better appreciation for how
they can deal with the uncertainties associated with cash flow We wrote Chapter 18 in response to students’ heightened inter-
forecasts. Capital rationing is also covered in Chapter 12. est in new business formation (entrepreneurship) and in order
to draw together, in a comprehensive way, the key concepts
Chapter 13 explains how the discount rates used in cap- from capital budgeting, working capital management, and fi-
ital budgeting are estimated. This chapter uses an innovative nancial policy. This capstone chapter provides an overview of
concept—that of the finance balance sheet—to help students practical finance issues associated with forecasting cash flows
develop an intuitive understanding of the relations between and capital requirements for a new business, preparing a busi-
the costs of the individual components of capital and the ness plan, and business valuation. The discussion of business
firm’s overall weighted average cost of capital. It also pro- valuation extends far beyond that found in other introductory
vides a detailed discussion of methods used to estimate the corporate finance textbooks.
costs of the individual components of capital that are used to
finance a firm’s investments and how these estimates are used Chapter on Options and Corporate Finance
in capital budgeting.
Many other corporate finance textbooks have a chapter that
Part 5 covers working capital management and financing introduces students to financial options and how they are
decisions. It begins, in Chapter 14, with an introduction to how valued. This chapter goes further. It provides a focused dis-
firms manage their working capital and the implications of cussion of the different types of financial and non-financial
working capital management decisions for financing decisions options that are of concern to financial managers, including
and firm value. This material is followed, in Chapters 15 and 16, options embedded in debt and equity securities, real options
with discussions of how firms raise capital to fund their real and their effect on project analysis, how option-like payoff
activities and the factors that affect how firms choose among functions faced by stockholders, bondholders, and managers
the various sources of capital available to them. Chapter 16 also affect agency relationships, and the use of options in risk
includes an extensive appendix on leasing concepts and buy vs. management.
lease analysis. Chapter 17 rounds out the discussion of financing

Proven Pedagogical Framework user-F396

c07RiskandReturn.indd Page 200 7/20/11 1:01:25 PM user-f396

We have developed several distinctive features throughout the book to aid
student learning. The pedagogical features included in our text are as follows:

CHAPTER OPENER VIGNETTES Learning Objectives

Each chapter begins with a © David Young-Wolff/PhotoEdit
vignette that describes a real
company or personal application. CHAPTER SEVEN 1 Explain the relation between risk and return. When Blockbuster Inc. filed for bankruptcy protection
The vignettes illustrate concepts 2
that will be presented in the 3 Describe the two components of a total on Thursday, September 23, 2010, its days as the dominant
chapter and are meant to 4 holding period return, and calculate this video rental firm were long gone. Netflix had become the most
heighten student interest, moti- 5 return for an asset.
vate learning, and demonstrate 6
the real-life relevance of the 7 Explain what an expected return is and successful competitor in the video rental market through its
material in the chapter.
200 calculate the expected return for an asset. strategy of renting videos exclusively online and avoiding the
LEARNING OBJECTIVES
Explain what the standard deviation of high costs associated with operating video rental stores.
The opening vignette is returns is and why it is very useful in finance, The bankruptcy filing passed control of Blockbuster to a
accompanied by learning and calculate it for an asset.
objectives that identify the group of bondholders, including the famous billionaire investor
most important material for Explain the concept of diversification. Carl Icahn, and the shares owned by the old stockholders be-
students to understand while came virtually worthless. The bondholders planned to reorga-
reading the chapter. At the
end of the chapter, the Discuss which type of risk matters to inves- nize the company and restructure its financing so that it had a
Summary of Learning Objec- tors and why. chance of competing more effectively with Netflix in the future.
tives summarizes the chapter
content in the context of the Describe what the Capital Asset Pricing Over the previous five years, Blockbuster stockholders had
learning objectives. Model (CAPM) tells us and how to use it to watched the value of their shares steadily decline as, year after
evaluate whether the expected return of an year, the company failed to respond effectively to the threat
asset is sufficient to compensate an investor posed by Netflix. From September 23, 2005 to September 23,
for the risks associated with that asset. 2010, the price of Blockbuster shares fell from $4.50 to $0.04. In
contrast, the price of Netflix shares rose from $24.17 to $160.47

over the same period. While the Blockbuster stockholders were

losing almost 100 percent of their investments, Netflix stock-

holders were earning an average return of 46 percent per year!

This chapter discusses risk, return, and the relation between them. The difference in the

returns earned by Blockbuster and Netflix stockholders from 2005 to 2010 illustrates a chal-

lenge faced by all investors. The shares of both of these companies were viewed as risky invest-

ments in 2005, and yet an investor who put all of his or her money in Blockbuster lost virtually

everything, while an investor who put all of his or her money in Netflix earned a very high

return. How should have investors viewed the risks of investing in these companys’ shares in

Calculating the Return on an Investment LEARNING
BY
PROBLEM: You purchased a beat-up 1974 Datsun 240Z sports car a year ago for APPLICATION 7.1
$1,500. Datsun is what Nissan, the Japanese car company, was called in the 1970s. The DOING
240Z was the first in a series of cars that led to the Nissan 370Z that is being sold today.
Recognizing that a mint-condition 240Z is a much sought-after car, you invested $7,000 user-F396
and a lot of your time fixing up the car. Last week, you sold it to a collector for $18,000.
Not counting the value of the time you spent restoring the car, what is the total return you
earned on this investment over the one-year holding period?

c07RiskandReturAn.iPndPdRPOagAeC23H1: 7/2U0/s1e1 E1:q01u:a5t8ioPnM u7s.e1r-ft3o96calculate the total holding period return. To cal-
culate RT using Equation 7.1, you must know P0, P1, and CF1. In this problem, you can
assume that the $7,000 was spent at the time you bought the car to purchase parts and

materials. Therefore, your initial investment, P0, was $1,500 ϩ $7,000 ϭ $8,500. Since
there were no other cash inflows or outflows between the time that you bought the car

and the time that you sold it, CF1 equals $0.

SOLUTION: The total holding period return is:

RT ϭ RCA ϩ RI ϭ P1 Ϫ P0 ϩ CF1 ϭ $18,000 Ϫ $8,500 ϩ $0 ϭ 1.118, or 111.8%
P0 $8,500

LEARNING BY DOING APPLICATION

Along with a generous number of in-text examples, most chapters include several

Learning by Doing Applications. These applications contain quantitative problems

with step-by-step solutions to help students better understand how to apply their

intuition and analytical skills to solve important problems. By including these

exercises, we provide students with additional practice in the application of the
concepts, tools, and methodsc07RiskandReturn.indd Page 202 7/20/11 1:01:30 PM user-f396 that are discussed in the text. user-F396

BUILDING MORE RISK MEANS A HIGHER BUILDING INTUITION
EXPECTED RETURN
Students must have an intuitive understanding of a number of
INTUITION The greater the risk associated with an invest- important principles and concepts to successfully master the
finance curriculum. Throughout the book, we emphasize these
ment, the greater the return investors expect important concepts by presenting them in Building Intuition
boxes. These boxes provide a statement of an important finance
from it. A corollary to this idea is that inves- concept, such as the relation between risk and expected return,
tors want the highest return for a given level of risk or the low- along with an intuitive example or explanation to help the student
“get” the concept. These boxes help the students develop
est risk for a given level of return. When choosing between two finance intuition. Collectively the Building Intuition boxes cover
investments that have the same level of risk, investors prefer the the most important concepts in corporate finance.
investment with the higher return. Alternatively, if two invest-
ments have the same expected return, investors prefer the less
risky alternative.

Choosing between Two Investments DECISION
MAKING
SITUATION: You are trying to decide whether to invest in one or both of two differ-
ent stocks. Stock 1 has a beta of 0.8 and an expected return of 7.0 percent. Stock 2 has EXAMPLE 7.2
a beta of 1.2 and an expected return of 9.5 percent. You remember learning about the
CAPM in school and believe that it does a good job of telling you what the appropriate
expected return should be for a given level of risk. Since the risk-free rate is 4 percent and
the market risk premium is 6 percent, the CAPM tells you that the appropriate expected
rate of return for an asset with a beta of 0.8 is 8.8 percent. The corresponding value for
an asset with a beta of 1.2 is 11.2 percent. Should you invest in either or both of these
stocks?

DECISION: You should not invest in either stock. The expected returns for both of
them are below the values predicted by the CAPM for investments with the same level
of risk. In other words, both would plot below the line in Exhibit 7.11. This implies that
they are both overpriced.

DECISION-MAKING EXAMPLES

Throughout the book, we emphasize the role of the financial manager as a decision maker.
To that end, twenty chapters include Decision-Making Examples. These examples, which
emphasize the decision-making process rather than computation, provide students with
experience in financial decision making. Each Decision-Making Example outlines a scenario
and asks the student to make a decision based on the information presented.

c07RiskandReturn.indd Page 233 7/20/11 1:02:01 PM user-f396 user-F396

END OF CHAPTER PEDAGOGY

SUMMARY OF LEARNING OBJECTIVES S um m a ry of Learning Objectives

AND KEY EQUATIONSReturn.indd Page 233 7/20/11 1:02:01 PM user-f396 1 Explain the relation betweenusreisr-kF3a9n6d return. 5 Explain the concept of diversification.

At the end of the chapter, you will find a Investors require greater returns for taking greater risk. They Diversification is reducing risk by investing in two or more as-
ummary of the key chapter content prefer the investment with the highest possible return for a given sets whose values do not always move in the same direction at
elated to each of the learning objectives level of risk or the investment with the lowest risk for a given the same time. Investing in a portfolio containing assets whose
level of return. prices do not always move together reduces risk because some
of the changes in the prices of individual assets offset each other.
2 Describe the two components of a total holding period This can cause the overall volatility in the value of an investor’s
return, and calculate this return for an asset. portfolio to be lower than if it consisted of only a single asset.

isted at the beginning of the chapter, as The total holding period return on an investment consists of a 6 Discuss which type of risk matters to investors and why.
well as an exhibit listing the key equations capital appreciation component and an income component. This
n the chapter. return is calculated using Equation 7.1. It is important to recog- Investors care about only systematic risk. This is because they
nize that investors do not care whether they receive a dollar of can eliminate unsystematic risk by holding a diversified portfo-
return through capital appreciation or as a cash dividend. Inves- lio. Diversified investors will bid up prices for assets to the point
tors value both sources of return equally. at which they are just being compensated for the systematic risks
they must bear.
3 Explain what an expected return is and calculate the
expected return for an asset. 7 Describe what the Capital Asset Pricing Model (CAPM)
tells us and how to use it to evaluate whether the ex-
The expected return is a weighted average of the possible returns pected return of an asset is sufficient to compensate an

S u m m a rf y io f Keh y Ehqfuhationis i h d b h

Equation Description Formula

7.1 Total holding period return RT ϭ RCA ϩ RI ϭ P1 Ϫ P0 ϩ CF1 ϭ ¢P ϩ CF1
P0 P0 P0

n

7.2 Expected return on an asset E1RAsset2 ϭ a 1 pi ϫ Ri2
i51

Self-Study Problems

7.1 Kaaran made a friendly wager with a colleague that involves the result from flipping a coin. If heads SELF-STUDY PROBLEMS WITH
comes up, Kaaran must pay her colleague $15; otherwise, her colleague will pay Kaaran $15. What SOLUTIONS
is Kaaran’s expected cash flow, and what is the variance of that cash flow if the coin has an equal
probability of coming up heads or tails? Suppose Kaaran’s colleague is willing to handicap the bet by Five problems similar to the in-text
paying her $20 if the coin toss results in tails. If everything else remains the same, what are Kaaran’s Learning by Doing Applications follow
expected cash flow and the variance of that cash flow? the summary and provide additional
F-4e04xamples with step-by-step solutionsF-404
7.2 You know that the price of CFI, Inc., stock will be $12 exactly one year from today. Today the price of to help students further develop
the stock is $11. Describe what must happen to the price of CFI, Inc., today in order for an investor their problem-solving and
to generate a 20 percent return over the next year. Assume that CFI does not pay dividends. computational skills.

7.3 The expected value of a normal distribution of prices for a stock is $50. If you are 90 percent sure that
the price of the stock will be between $40 and $60, then what is the variance of the stock price?

7.4 You must choose between investing in stock A or stock B. You have already used CAPM to calculate

the rate of return you should expect to receive for each stock given their systematic risk and decided

that the expected return for both exceeds that predicted by CAPM by the same amount. In other

words, both are equally attractive investments for a diversified investor. However, since you are still
c07RisinkasncdhRoeotluarnn.dindddoPnaogteh2a3v4e a7l/o2t2/o1f1m2o:1n0e:y3,0yPouMruinsevresf-t4m04ent portfolio is not diversified. You have de-

Solutions to Self-Study Problemscided to invest in the stock that has the highest expected return per unit of total rics0k7.RIfistkhaenedxRpeetucrtne.dindd Page 234 7/22/11 2:10:30 PM user f-404

d d dd i i f f k A 10 d 25 il d

7.1 Part 1: E1cash flow2 ϭ 10.5 ϫ Ϫ$152 ϩ 10.5 ϫ $152 ϭ 0

sC2 ash flow ϭ 3 0.5 ϫ 1Ϫ$15 Ϫ $022 4 ϩ 3 0.5 ϫ 1$15 Ϫ $022 4 ϭ $225
Part 2: E1cash flow2 ϭ 10.5 ϫ Ϫ$152 ϩ 10.5 ϫ $202 ϭ $2.50

s2Cash flow ϭ 3 0.5 ϫ 1Ϫ$15 Ϫ $2.5022 4 ϩ 3 0.5 ϫ 1$20 Ϫ $2.5022 4 ϭ $306.25

7.2 The expected return for CFI based on today’s stock price is ($12 Ϫ $11)/$11 ϭ 9.09 percent, which is
lower than 20 percent. Since the stock price one year from today is fixed, the only way that you will
generate a 20 percent return is if the price of the stock drops today. Consequently, the price of the
stock today must drop to $10. It is found by solving the following: 0.2 ϭ ($12 Ϫ x)/x, or x ϭ $10.

7.3 Since you know that 1.645 standard deviations around the expected return captures 90 percent of
the distribution, you can set up either of the following equations:

$40 ϭ $50 Ϫ 1.645s or $60 ϭ $50 ϩ 1.645s

and solve for s . Doing this with either equation yields:

s ϭ $6.079 and s2 ϭ 36.954

7.4 A comparison of the Sharpe Ratios for the two stocks will tell you which has the highest expected
return per unit of total risk.

SA ϭ E1RA2 Ϫ Rrf ϭ 0.10 Ϫ 0.05 ϭ 0.20
sRA 0.25

SB ϭ E1RB2 Ϫ Rrf ϭ 0.15 Ϫ 0.05 ϭ 0.25
sRB 0.40

CRITICAL THINKING QUESTIONS Critical Thinking Questions

At least ten qualitative questions, 7.1 Given that you know the risk as well as the expected return for two stocks, discuss what process
called Critical Thinking Questions, you might utilize to determine which of the two stocks is a better buy. You may assume that the
equire students to think through two stocks will be the only assets held in your portfolio.
heir understanding of key concepts
and apply those concepts to a 7.2 What is the difference between the expected rate of return and the required rate of return? What
problem. does it mean if they are different for a particular asset at a particular point in time?

7.3 Suppose that the standard deviation of the returns on the shares of stock at two different compa-
nies is exactly the same. Does this mean that the required rate of return will be the same for these
two stocks? How might the required rate of return on the stock of a third company be greater than
the required rates of return on the stocks of the first two companies even if the standard deviation
of the returns of the third company’s stock is lower?

7.4 The correlation between stocks A and B is 0.50, while the correlation between stocks A and C is
Ϫ0.5. You already own stock A and are thinking of buying either stock B or stock C. If you want
your portfolio to have the lowest possible risk, would you buy stock B or C? Would you expect the
stock you choose to affect the return that you earn on your portfolio?

Questions and Problems

7.1 Returns: Describe the difference between a total holding period return and an expected return. > BASIC

QUESTIONS AND PROBLEMS 7.2 Expected returns: John is watching an old game show rerun on television called Let’s Make a
Deal in which the contestant chooses a prize behind one of two curtains. Behind one of the cur-
The Questions and Problems, tains is a gag prize worth $150, and behind the other is a round-the-world trip worth $7,200. The
numbering 26 to 44 per chapter, are game show has placed a subliminal message on the curtain containing the gag prize, which makes
primarily quantitative and are the probability of choosing the gag prize equal to 75 percent. What is the expected value of the
classified as Basic, Intermediate, or selection, and what is the standard deviation of that selection?
Advanced.
7.3 Expected returns: You have chosen biology as your college major because you would like to be a
medical doctor. However, you find that the probability of being accepted to medical school is about
10 percent. If you are accepted to medical school, then your starting salary when you graduate will be
$ f d h ld h k h

7.13 Expected returns: Jose is thinking about purchasing a soft drink machine and placing it in a busi- < INTERMEDIATE
ness office. He knows that there is a 5 percent probability that someone who walks by the machine will
make a purchase from the machine, and he knows that the profit on each soft drink sold is $0.10. If user-F396
Jose expects a thousand people per day to pass by the machine and requires a complete return of his

c07RiskainndvResettmurenn.int dind oPnaegeye2a3r7, th7/e2n0/w11ha1t :i0s2t:h0e4 mPMaxuimseur-mf39p6rice that he should be willing to pay for the soft
drink machine? Assume 250 working days in a year and ignore taxes and the time value of money.

7.14 Interpreting the variance and standard deviation: The distribution of grades in an
introductory finance class is normally distributed, with an expected grade of 75. If the standard

ADVANCED > 7.27 David is going to purchase two stocks to form the initial holdings in his portfolio. Iron stock has

an expected return of 15 percent, while Copper stock has an expected return of 20 percent. If

David plans to invest 30 percent of his funds in Iron and the remainder in Copper, what will be the

expected return from his portfolio? What if David invests 70 percent of his funds in Iron stock?

CFA PROBLEMS > 11.37 FITCO is considering the purchase of new equipment. The equipment costs $350,000, and an addi- CFA PROBLEMS

tional $110,000 is needed to install it. The equipment will be depreciated straight-line to zero over a Problems from CFA readings are
five-year life. The equipment will generate additional annual revenues of $265,000, and it will have included in the Question and Prob-
annual cash operating expenses of $83,000. The equipment will be sold for $85,000 after five years. lem section in appropriate chapters.
An inventory investment of $73,000 is required during the life of the investment. FITCO is in the
40 percent tax bracket, and its cost of capital is 10 percent. What is the project NPV? user-f396
a. $47,818.
b. $63,658.
c. $80,189.
d. $97,449.

c05TheTimeValueOfMoney.indd Page 158 8/4/11 10:22:47 AM user-f396

158 CHAPTER 5 I The Time Value of Money EXCEL PROBLEMS

5.35 Sam Bradford, a number 1 draft pick of the St. Louis Rams, and his agent are evaluating three Nearly all problems can be solved
contract options. Each option offers a signing bonus and a series of payments over the life of the using Excel templates at the student
contract. Bradford uses a 10.25 percent rate of return to evaluate the contracts. Given the cash Web site within WileyPLUS.
flows for each option, which one should he choose?

Year Cash Flow Type Option A Option B Option C

0 Signing Bonus $3,100,000 $4,000,000 $4,250,000

1 Annual Salary $ 650,000 $ 825,000 $ 550,000

2 Annual Salary $ 715,000 $ 850,000 $ 625,000

3 Annual Salary $ 822,250 $ 925,000 $ 800,000

SAMPLE TEST PROBLEMS Sample Test Problems

Finally, five Sample Test Problems call for 7.1 Friendly Airlines stock is selling at a current price of $37.50 per share. If the stock does not pay a dividend
straightforward applications of the chapter and has a 12 percent expected return, what is the expected price of the stock one year from today?
concepts. These problems are intended to be
representative of the kind of problems that 7.2 Stefan’s parents are about to invest their nest egg in a stock that he has estimated to have an expected
may be used in a test, and instructors can return of 9 percent over the next year. If the return on the stock is normally distributed with a 3 percent
encourage students to solve them as if they standard deviation, in what range will the stock return fall 95 percent of the time?
were taking a quiz. Solutions are provided in
the Instructor’s Manual. 7.3 Elaine has narrowed her investment alternatives to two stocks (at this time she is not worried about
diversifying): Stock M, which has a 23 percent expected return, and Stock Y, which has an 8 percent
expected return. If Elaine requires a 16 percent return on her total investment, then what proportion
of her portfolio will she invest in each stock?

7.4 You have just prepared a graph similar to Exhibit 7.9, comparing historical data for Pear Computer Corp.
and the general market. When you plot the line of best fit for these data, you find that the slope of that line
is 2.5. If you know that the market generated a return of 12 percent and that the risk-free rate is 5 percent,
then what would your best estimate be for the return of Pear Computer during that same time period?

7.5 The CAPM predicts that the return of MoonBucks Tea Corp. is 23.6 percent. If the risk-free rate of re-
turn is 8 percent and the expected return on the market is 20 percent, then what is MoonBucks’ beta?

END OF PART ETHICS CASES breaches of confidentiality, and are presented, including timeless
breaches of fiduciary duty (principal- cases about Arthur Anderson and
Ethics is an important topic in finance agent relationships); we highlight Martha Stewart’s scandal involving
and this text addresses ethical issues examples of such analysis through- ImClone, and more timely topics
in several ways. In Chapter 1, we out the text. In addition, seven ethics such as the subprime mortgage
introduce a framework for consider- cases are included throughout this crisis and the advent of sustainable
ation of ethical issues in corporate book in order to help students better living plans by corporations. Each
finance. Many ethical issues can be understand how to analyze ethical case includes questions for follow-
analyzed in the context of informa- dilemmas in the context of the up discussion in class or as an
tional asymmetry between parties to framework. Real company examples assignment.
a transaction, conflicts of interest,

New to This Edition

In revising Fundamentals of Corporate Finance we have improved the presentation
and organization of key topics, added important new content, updated the text to
reflect changes in market and business conditions since the first edition was written,
improved key in-chapter pedagogical features, added to the number and quality of
the end-of-chapter problem sets, and updated the ethics cases.

Improved Presentation and Organization

We have edited and extended discussions throughout the text in an effort to im-
prove the pedagogical presentation of key topics. We also have rearranged the or-
der of some material to improve the effectiveness of the presentation. For example,
the discussion of the stock market (Section 2.4 in the first edition) has been incorpo-
rated into the section on the market for stocks in Chapter 9 and new content on in-
ternational stock markets has been added to this discussion. This change improves
the flow of the text and provides a more natural lead-in to the stock valuation con-
cepts that are subsequently discussed in Chapter 9. Also, material on capital market
efficiency (Section 8.1 in the first edition) has being moved to the initial discussion of
financial markets in Chapter 2. This change introduces the student to the concept of
market efficiency earlier in the book and improves the focus of Chapter 8, which
discusses bond valuation and interest rates.

New Content

There have been numerous additions to the content of the book. Some of the most
noteworthy include the following. A new section on cash flows to investors has been
added to Chapter 3 immediately after the discussion of how the financial statements
tie together (Section 3.6 in the first edition). This new section helps students develop
an understanding of the sources and uses of investor cash flows in the context of
the discussion of financial statements. It also enables them to develop an intuitive
understanding of the importance of cash flows to investors prior to the chapters on
the time value of money, risk and return, capital budgeting, and valuation.

A discussion of the Sharpe Ratio has being incorporated into Section 7.4, im-
mediately after the existing material on the coefficient of variation. This discussion
helps students develop a stronger intuition about the relation between risk and re-
turn earlier in the book.

An extensive discussion of leasing policy and analysis has been added as an ap-
pendix to the chapter on financial policy, Chapter 16. This section introduces students
to leasing as an alternative means of financing the acquisition of an asset, outlines the
conflicts that can arise in lease agreements and mechanisms for reducing the costs of
these conflicts, discusses why certain types of assets are more or less likely to be
leased, and summarizes how financial managers make buy vs. lease decisions. This
material is presented within the same agency framework used in Chapter 16 and can
be taught in conjunction with the rest of Chapter 16, or independently.

The discussion of options in Chapter 20 has been extended to include diff-
erent types of options embedded in the debt and equity securities that firms issue.

NEW TO THIS EDITION xvii

This discussion provides students with a more complete picture of the range of fi-
nancial and non-financial options that are of concern to financial managers.

Current Financial Market and Business Information

Throughout the text, all financial market and business information for which more
current data are available have been updated. Not only have the exhibits been up-
dated, but financial values such as interest rates, risk premia, and foreign currency
exchange rates have been updated throughout the discussions in text, in-text
examples, and end-of-chapter problems. In addition, 19 of the 21 chapter opener
vignettes are completely new. Eighteen of these examples are from 2010, and one is
from 2009. The remaining two opener vignettes have been edited to ensure that
they remain current. All of the chapter openers provide timely examples of how the
material covered in the chapter is relevant to financial decision-making.

In-Chapter Features

The Learning Objectives at the beginning of each chapter have been revised to
more fully reflect the important content in the associated sections of the chapters.

New Building Intuition Boxes have been added where appropriate and existing
Building Intuition Boxes have been edited to ensure clarity.

All Learning by Doing Applications have been reviewed and, where appropriate,
updated or replaced.

All existing Decision-Making Examples have been reviewed and updated where nec-
essary. In addition, six new Decision-Making Examples have been added to the text.

The Summary of Learning Objectives and Key Equations at the end of each chapter
have been updated to reflect other changes in the chapter and to improve the ped-
agogical value of these features.

Refined and Extended Problem Sets

We have carefully edited the end-of-chapter questions and problems throughout the
book to ensure that the examples are current and clearly presented. In addition, new
questions and problems have been added to ensure appropriate coverage of key
concepts at all levels of difficulty. A total of 96 new questions and problems have
been added to the end-of-chapter problem sets, which brings the total number of
end-of-chapter questions and problems, including self-study problems and self-test
questions, for the entire text to 1,184.

Updated Ethics Cases and Their Organization

The Schwan Foods case has been replaced at the end of Chapter 11 with a new
case concerning the Unilever global Sustainable Living Plan. This case challenges
the student to think about how a sustainability plan can be consistent with stock-
holder value maximization. In addition, the case on affinity credit cards at the end
of Chapter 6 has been updated to reflect the effects of the Credit Card Act of 2009
and new data on the use of these cards as of 2010. The case on the Subprime Mort-
gage Market Meltdown has been moved from the end of Chapter 18 to the end of
Chapter 8 so that students can address the timely issues raised in this case earlier in
the course.

Instructor and Student Resources

Fundamentals of Corporate Finance Second Edition features a WileyPLUS for Fundamentals of Corporate Finance, Second
ull line of teaching and learning resources that were devel- Edition includes numerous valuable resources, among them:
oped under the close review of the authors. Driven by the same
basic beliefs as the textbook, these supplements provide a con- • Animated Learning by Doing Applications
istent and well-integrated learning system. This hands-on • Wiley Corporate Finance Video Collection
package guides instructors through the process of active learn- • Prerequisite Course Reviews
ng and provides them with the tools to create an interactive • Animated Tutorials
earning environment. With its emphasis on activities, exer- • Excel Templates and Spreadsheet Solutions
ises, and the Internet, the package encourages students to take • Flashcards
n active role in the course and prepares them for decision • Crosswords
making in a real-world context. • Narrated PowerPoint Review
• Student Study Guide
WileyPLUS is a research-based, online • Hot Topics Modules
environment for effective teaching and • Learning Styles Survey
learning. WileyPLUS builds students’ con-
fidence because it takes the guesswork out Book Companion Site—For Instructors.
of studying by providing students with a clear roadmap:
what to do, how to do it, if they did it right. This interactive An extensive support package, including print and technology
pproach focuses on: tools, helps you maximize your teaching effectiveness. We offer
useful supplements for instructors with varying levels of expe-
Design: Research-based design is based on proven instruc- rience and different instructional circumstances.
ional methods. Content is organized into small, more acces-
ible amounts of information, helping students build better On this Web site instructors will find electronic versions of the
ime management skills. Solutions Manual, Test Bank, Instructor’s Manual, Computer-
ized Test Bank, and other valuable resources: www.wiley.com/
Engagement: Students can visually track their progress as they college/Parrino.
move through the material at a pace that is right for them. En-
gaging in individualized self-quizzes followed by immediate Instructor’s Manual. Included for each chapter are lecture
eedback helps to sustain their motivation to learn. outlines, a summary of learning objectives and key equations, and
alternative approaches to the material. The Solutions Manual
Outcomes: Self-assessment lets students know the exact out- includes detailed solutions to the Before You Go On questions,
ome of their effort at any time. Advanced reporting allows Self-Study problems, Critical Thinking Questions, and all of the
nstructors to easily spot trends in the usage and performance Questions and Problems at the end of each chapter.
data of their class in order to make more informed decisions.
Test Bank. With over 2000 questions, the test bank allows
With WileyPLUS, students will always know: instructors to tailor examinations according to study objec-
tives and difficulty. Multiple-choice, true/false, and essay ques-
What to do: Features, such as the course calendar, help stu- tions are included.
dents stay on track and manage their time more effectively.
How to do it: Instant feedback and personalized learning Computerized Test Bank. The computerized test bank
plans are available 24/7. allows instructors to create and print multiple versions of the
If they’re doing it right: Self-evaluation tools take the guesswork
out of studying and help students focus on the right materials.

INSTRUCTOR AND STUDENT RESOURCES xix

same test by scrambling the order of all questions found in the Ken Bishop, Florida Atlantic University
Word version of the test bank. The computerized test bank also David Blackwell, Texas A&M University
allows users to customize exams by altering or adding new Charles Blaylock, Murray State University
problems. Vigdis Boasson, Central Michigan University
Carol Boyer, William Patterson University
PowerPoint Presentations. The PowerPoint presenta- David Bourff, Boise State University
tions contain a combination of key concepts, figures and tables, Joe Brocato, Tarleton State University
and problems and examples from the textbook as well as lec- Jeffrey Brookman, Idaho State University
ture notes and illustrations. Jeff Bruns, Bacone College
James Buck, East Carolina University
WebCT and Angel. WebCT or Angel offer an integrated set of Juan Cabrera, Ramapo College
course management tools that enable instructors to easily design, Michael Carter, University of North Texas—Dallas
develop and manage Web-based and Web-enhanced courses. Theodore Chadwick, Boston University
Surya Chelikani, Quinnipiac University
Book Companion Site — For Students. Ji Chen, University of Colorado Denver
Jun Chen, University of North Carolina at Charlotte
The Fundamentals of Corporate Finance student Web site pro- Yea-Mow Chen, San Francisco State University
vides a wealth of support materials that will help students de- Paul Chiou, Shippensburg University
velop their conceptual understanding of class material and in- William Chittenden, Texas State University
crease their ability to solve problems. On this Web site students Tarun Chordia, Emory University
will find Excel templates, study tools, Web quizzing, and other Ting-Heng Chu, East Tennessee State University
resources: www.wiley.com/college/Parrino. Cetin Ciner, University of North Carolina at Wilmington
Jonathan Clarke, Georgia Tech
ACKNOWLEDGMENTS Thomas Coe, Quinnipiac University
Hugh Colaco, Merrimack College
The nearly 300 colleagues listed below provided valuable feed- Colene Coldwell, Baylor University
back during the development process and added greatly to the Boyd D. Collier, Tarleton State University
content and pedagogy of the book. Their commitment to teach- Roger Collier, Northeastern State University
ing and willingness to become involved in such a project was a Lary B. Cowart, The University of Alabama at Birmingham
source of inspiration to the authors. We would like to acknowl- Susan J. Crain, Missouri State University
edge the contribution made by the following professors whose Tony Crawford, University of Montana
thoughtful comments contributed to the quality, relevancy, and Sandeep Dahiva, Georgetown University
accuracy of the first and second editions of this text: Julie Dahlquist, University of Texas at San Antonio
Brent Dalrymple, University of Central Florida
Reviewers Amadeu DaSilva, California State University, Fullerton
Sergio Davalos, University of Washington
Saul Adelman, Miami University Diane Del Guercio, University of Oregon
Kenneth Ahern, University of Michigan Zane Dennick-Ream, Robert Morris University
Esther Ancel, University of Wisconsin—Milwaukee John Dexter, Northwood University
Ronald Anderson, American University Robert Dildine, Metropolitan State University
Gene Andrusco, California State University San Bernardino Robert Dubil, University of Utah
Evrim Akdogu, Southern Methodist University Heidi Dybevik, University of Iowa
Kofi Amoateng, North Carolina Central University Michael Dyer, University of Illinois at Urbana-Champaign
Kavous Ardalan, Marist College David Eckmann, University of Miami
Bala Arshanapalli, Indiana University Northwest Susan Edwards, Grand Valley State University
Saul Auslander, Bridgewater State College Ahmed El-Shahat, Florida International University
Alan Bailey, University of Texas San Antonio Frank Elston, Concordia College
Robert Balik, Western Michigan University Maryellen Epplin, University of Central Oklahoma
John Banko, University of Florida Stephen Ferris, University of Missouri Columbia
Babu Baradwaj, Towson University Ron Filante, Pace University
Nina Baranchuk, University of Texas at Dallas J. Howard Finch, Florida Gulf Coast University
Karen Barnhart, Missouri State University Kathy Fogel, Northern Kentucky University
Janet Bartholow, Kent State University Joann Fredrickson, Bemidji State University
John Becker-Blease, Washington State University Sharon Garrison, University of Arizona
Omar Benkato, Ball State University Louis Gasper, University of Dallas
Vashishta Bhaskar, Duquesne University John Gawryk, Central Michigan University
Wilfred Jerome Bibbins, Troy University Edward Graham, University of North Carolina at Wilmington
Hamdi Bilici, California State University Long Beach Richard P. Gregory, East Tennessee State University

xx INSTRUCTOR AND STUDENT RESOURCES Mingsheng Li, Bowling Green State University
Bing Liang, University of Massachusetts Amherst
Nicolas Gressis, Wright State University Wendell Licon, Arizona State University Tempe
Anthony Gu, SUNY Geneseo Steven Lifland, High Point University
Roxane Gunser, University of Wisconsin Platteville Ralph Lim, Sacred Heart University
Manak Gupta, Temple University Bingxuan Lin, University of Rhode Island
ally Guyton, Texas A&M University Hong-Jen Lin, Brooklyn College
Matthew Haertzen, Northern Arizona University Jason Lin, Truman State University
Karen Hallows, George Mason University David Lins, University of Illinois
Karen Hamilton, Georgia Southern University Peter Locke, George Washington State University
ohn Hatem, Georgia Southern University Robert Lutz, University of Utah
George Haushalter, Pennsylvania State University Yulong Ma, California State University Long Beach
Andrew Head, Western Kentucky University Y. Lal Mahajan, Monmouth University
Matthew Hood, University of Southern Mississippi Dana Manner, University of Miami
ames Howard, University of Maryland University College Carol Mannino, Milwaukee School of Engineering
ian Huang, Washington State University Timothy Manuel, University of Montana
Christy Huebner Caridi, Marist College Barry Marchman, Georgia Tech
tephen Huffman, University of Wisconsin Oshkosh Richard Mark, Dowling College
Rob Hull, Washburn University Brian Maris, Northern Arizona University
Kenneth Hunsader, University of South Alabama Rand Martin, Bloomsburg University of Pennsylvania
ae-Kwang Hwang, Virginia State University Richmond Mathews, Duke University
Zahid Iqbal, Texas Southern University Leslie Mathis, University of Memphis
ide Iwawere, Howard University Stefano Mazzotta, Kennesaw State University
Benjamas Jirasakuldech, Slippery Rock University Joseph McCarthy, Bryant University
urendranath Jory, University of Michigan at Flint Lee McClain, Western Washington University
arl Kallberg, New York University Michael McNamara, Washington State University
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ames Kehr, Miami University of Ohio Jill Misuraca, Central Connecticut State University
Peppi Kenny, Western Illinois University Sunil Mohanty, University of St. Thomas
ames Keys, Florida International University Dianne Morrison, University of Wisconsin, La Crosse
Robert Kieschnick, University of Texas Dallas Shane Moser, University of Mississippi
aemin Kim, San Diego State University Michael Muoghalu, Pittsburg State University
Kee Kim, Missouri State University Suzan Murphy, University of Tennessee
Kenneth Kim, SUNY Buffalo Dina Naples-Layish, SUNY Binghamton
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ohn Knight, University of the Pacific Chee Ng, Fairleigh Dickinson University
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Frances Kwansa, University of Delaware Nick Panepinto, Flagler College
ulia Kwok, Northeastern State University Coleen Pantalone, Northeastern University
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tephen Lacewell, Murray State University Ivelina Pavlova, University of Houston, Clear Lake
Gene Lai, Washington State University Anil Pawar, San Diego State University
Mark Laplante, University of Georgia Janet Payne, Texas State University
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erry Leabman, Bentley College G. Michael Phillips, California State University Northridge
Gregory LeBlanc, University of California Berkeley James Philpot, Southwest Missouri State University
Rick Le Compte, Wichita State University Greg Pierce, Pennsylvania State University
Alice Lee, San Francisco State University Steve Pilloff, George Mason University
Cheng Few Lee, Rutgers University Wendy Pirie, Valparaiso University
eong Lee, University of North Dakota Tony Plath, University of North Carolina, Charlotte
Richard Lee, Barton College
Canlin Li, University of California at Riverside

INSTRUCTOR AND STUDENT RESOURCES xxi

Vassilis Polimenis, University of California Riverside Sergey Tsyplakov, University of South Carolina
Percy Poon, University of Nevada Las Vegas David Tufte, Southern Utah University
Terry Pope, Abilene Christian University Cathyann Tully, Kean University
Gary Powell, Towson University Marian Turac, Georgia State University
Richard Powell, Villanova University Harry Turtle, Washington State University
Dev Prasad, University of Massachusetts Lowell Pieter Vandenberg, San Diego State University
Rose Prasad, Central Michigan University Bonnie Van Ness, University of Mississippi
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Robert Puelz, Southern Methodist University Zoë L. Van Schyndel, University of Miami
Russell B. Raimer, Cleveland State University Sanjay Varshney, SUNY Institute of Technology
S. Rao, University of Louisiana at Lafayette Rahul Verma, University of Houston Downtown
Vadhindran K. Rao, Metropolitan State University Jill Lynn Vihtelic, Saint Mary’s College
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Greg Richey, California State University, San Bernadino Jonathan Wagoner, Fairmont State University
Hong Rim, Shippensburg University Joe Walker, University of Alabama at Birmingham
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Sundarrajan Sankar, Tarleton State University Yangru Wu, Rutgers Business School
Mukunthan Santhanakrishnan, Idaho State University Feixue Xie, University of Texas at El Paso
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Steven Scheff, Florida Gulf Coast University Devrim Yaman, Western Michigan University
George Seldat, Southwest Minnesota State University Hua Yang, Old Dominion University
Vivek Sharma, University of Michigan Dearborn David Yamoah, Kean University
Val Sibilkov, University of Wisconsin, Milwaukee Keven Yost, Auburn University
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Betty Simkins, Oklahoma State University Stillwater Jasmine Yur-Austin, California State University, Long Beach
Sudhir Singh, Frostburg State University David Zhang, Arizona State University West
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Gene Stout, Central Michigan University
David Suk, Rider University Francisca M. Beer, California State University, San Bernardino
Charlene Sullivan, Purdue University Susan J. Crain, Missouri State University
Michael Sullivan, University of Nevada at Las Vegas Praveen Kumar Das, University of Louisiana
Alice Sun, California State Polytechnic University Pomona Amadeu DaSilva, California State University, Fullerton
Srinivasan Sundaram, Ball State University Beverly Hadaway, The University of Texas at Austin
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Robert Sweeney, Wright State University G. Michael Phillips, California State University, Northridge
Philip Swensen, Utah State University Helen Saar, University of Hawaii, Manoa
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Thomas Tallerico, Dowling College Devrim Yaman, Western Michigan University
Richard Taylor, Arkansas State University Jasmine Yur-Austin, California State University, Long Beach
Bill Templeton, Butler University Kermit C. Zieg, Florida Institute of Technology
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Rhonda Tenkku, University of Missouri at St. Louis Class Testers
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Harold Thiewes Minnesota State University Babu Baradwaj, Towson University
Paul Thistle, University of Nevada at Las Vegas Jeffrey Brookman, Idaho State University
Nancy Titus-Piersma, Oklahoma State at Stillwater Juan Cabrera, Ramapo College
Damir Tokic, University of Houston Downtown Michael Carter, University of North Texas
K.C. Tseng, California State University Fresno

xxii INSTRUCTOR AND STUDENT RESOURCES The following people developed and
revised valuable student and instructor
un Chen, University of North Carolina at Charlotte resources available on the book
onathan Clarke, Georgia Tech companion site and WileyPLUS:
Thomas Coe, Quinnipiac College
Hugh Colaco, Merrimack College Babu Baradwaj, Towson University
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Roger Collier, Northeastern State University Michael Carter, University of North Texas, Dallas
ames Cordiero, The College at Brockport, State University of New York James DeMello, Western Michigan University
rving DeGraw, St. Petersburg Junior College James Dow, G. Michael Phillips, Kenneth Leslie, California State
Zane Dennick-Ream, Robert Morris College
Michael Dyer, University of Illinois, Urbana-Champaign University, Northridge
Ronald Filante, Pace University James Keys, Florida International University
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Richard Gregory, East Tennessee State University Wendell Licon, Arizona State University
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Matthew Haertzen, Northern Arizona University Bridget Lyons, Sacred Heart University
Karen L. Hamilton, Georgia Southern University Dianne Morrison, University of Wisconsin, La Crosse
Gary Kayakachoian, University of Rhode Island Mary Lou Poloskey, The University of Texas at Austin
Peppi Kenny, Western Illinois University Philip Thames, California State University, Long Beach
ulia Kwok, Northeastern State University Susan White, University of Maryland
Pamela LaBorde, Western Washington University Devrim Yaman, Western Michigan University
Duong Le, University of Arkansas at Little Rock
Mingsheng Li, Bowling Green State University Contributor Team
Wendell Licon, Arizona State University
teven Lifland, High Point University We owe a special thanks to members of the contributor team
ason Lin, Truman State University for their hard work, exceptional creativity, consummate com-
Hong-Jen Lin, Brooklyn College munications skills, and advice: Dr. Babu Baradwaj of Towson
Robert Lutz, University of Utah State University and Dr. Wendell Licon of Arizona State Uni-
Brian A. Maris, Northern Arizona University versity who wrote the Instructor’s Manual, student Study
uzan Murphy, University of Tennessee Guide, and major sections of the end-of-chapter materials for
. P. UMA Rao, University of Louisiana at Lafayette the First Edition. Dr. Norm Bowie of the University of Min-
Luis Rivera, Dowling College nesota wrote most of the ethics cases. Petra Kubalova, of the
David Rystrom, Western Washington University Schwan Food Company, worked extensively with Professor
Murray Sabrin, Ramapo College Kidwell on this project during and after completing her MBA
Michael Sullivan, University of Nevada at Las Vegas studies at Georgetown University. Dr. Zekiye Selvili of Univer-
Chu-Sheng Tai, Texas Southern University sity of Southern California, Steven Gallaher of Southern New
Thomas Tallerico, Dowling College Hampshire University, and Nicholas Crane of University of
Diana Tempski, University of Wisconsin, La Crosse Texas at Austin also contributed in a number of areas.
onathan Wagoner, Fairmont State College
Publishing Team
Accuracy Checkers
We also thank the publishing team who was always calm, sup-
Robert J. Balik, Western Michigan University portive, and gracious under fire as we suffered the travail of
Babu Baradwaj, Towson University college textbook writing and revising, where deadlines are
im P. DeMello, Western Michigan University always yesterday. Those showing extraordinary patience and
haron Garrison, University of Arizona support include Joseph Heider, Senior Vice President and
anjay Jain, Salem State University General Manager; Timothy Stookesberry, Vice President, Product
Mary Lou Poloskey, The University of Texas at Austin and eBusiness Development; George Hoffman, Vice President
nayat U. Mangla, Western Michigan University and Executive Publisher; and Susan Elbe, Vice President, Market
ill Misuraca, University of Tampa Development and Marketing. Those warranting special praise
Dianne Morrison, University of Wisconsin are Jennifer Manias, Project Editor, who coordinated the com-
Napoleon Overton, University of Memphis plex scheduling of the book and all of its resources; Amy
Craig A. Peterson, Western Michigan University Scholz, Associate Director of Marketing; and the Wiley sales
ames Philpot, Missouri State University force for their creativity and success in selling our book. Other
udith Swisher, Western Michigan University Wiley staff who contributed to the text and media include
Rhonda Tenkku, University of Missouri

INSTRUCTOR AND STUDENT RESOURCES xxiii

Barbara Heaney, Director of Product and Market Develop- to share their intellectual capital. George Kaufman and Michael
ment; Howard Averback, Instructional Designer; Emily Mc- Hopewell who contributed to Dr. Kidwell’s knowledge of eco-
Gee and Erica Horowitz, Editorial Assistants; Courtney Luzzi, nomics and finance and were critical professors during his
Marketing Assistant; Allie Morris, Senior Product Designer; doctoral program at the University of Oregon. Richard West,
and Greg Chaput, Product Designer; William Murray, Senior former dean and professor at the University of Oregon, who
Production Editor; Maureen Eide, Senior Designer; and unlocked the secrets of research and inspired Dr. Kidwell’s
Jennifer MacMillan, Senior Photo Editor. love of teaching and scholarship. Robert Johnson of Purdue
University whose dignity and academic bearing served as an
Colleagues academic role model and whose love of teaching and research
inspired Dr. Kidwell to follow in his footsteps and to write
Robert Parrino would also like to thank some of his colleagues this book. David Blackwell of Texas A&M University who
for their inspiration and helpful discussions. Among those who helped conceptualize the idea for the book and contributed
have significantly influenced this book are Robert Bruner of numerous insights to various chapters during the book’s writ-
University of Virginia, Jay Hartzell of University of Texas at Aus- ing. Finally, to John Harbell and Jonas Mittelman, of San
tin, and Mark Huson of University of Alberta. Special thanks are Francisco State University who started Dr. Kidwell on his
owed to Clifford Smith, of University of Rochester, whose classes academic journey.
really helped one author make sense of finance. In addition, rec-
ognition should go to Michael J. Barclay, who inspired genera- Thomas Bates would like to thank the professors, co-
tions of students through his selfless support and example and authors, and colleagues who have made him a better scholar
who was both a great researcher and teacher. and educator, including Robert Williams, who first introduced
him to the analytical elegance of economics, and Kenneth Lehn
David Kidwell would like to thank some of his former who inspired him to pursue excellence in research and teach-
professors and colleagues for their inspiration and willingness ing in the field of finance.

Brief Contents

PART 1 INTRODUCTION 1 2 Evaluating Project Economics and Capital

1 The Financial Manager and the Firm 1 Rationing 380

PART 2 FOUNDATIONS 1 3 The Cost of Capital 409

2 The Financial System and the Level of PART 5 WORKING CAPITAL MANAGEMENT
AND FINANCING DECISIONS
Interest Rates 27
1 4 Working Capital Management 441
3 Financial Statements, Cash Flows, 1 5 How Firms Raise Capital 472
1 6 Capital Structure Policy 504
and Taxes 48 1 7 Dividends, Stock Repurchases, and Payout

4 Analyzing Financial Statements 81 Policy 561

PART 3 VALUATION OF FUTURE CASH PART 6 BUSINESS FORMATION,
FLOWS AND RISK VALUATION, AND FINANCIAL
PLANNING
5 The Time Value of Money 124
6 Discounted Cash Flows and Valuation 159 1 8 Business Formation, Growth,
7 Risk and Return 200
8 Bond Valuation and the Structure of Interest and Valuation 569

Rates 238 1 9 Financial Planning and Forecasting 606

9 Stock Valuation 270 PART 7 OPTIONS IN CORPORATE
FINANCE AND INTERNATIONAL
PART 4 CAPITAL BUDGETING DECISIONS DECISIONS

1 0 The Fundamentals of Capital 2 0 Options and Corporate Finance 641
2 1 International Financial Management 671
Budgeting 301

1 1 Cash Flows and Capital Budgeting 341

Contents

PART 1 INTRODUCTION Building Intuition: The Timing of Cash Flows Affects
Their Value 11 Building Intuition: The Riskiness of
1C H A P T E R Cash Flows Affects Their Value 12 Maximize the
Value of the Firm’s Stock 12 Building Intuition:
The Financial Manager and the Firm 1 The Financial Manager’s Goal Is to Maximize the
Value of the Firm’s Stock 12 Can Management
1.1 THE ROLE OF THE FINANCIAL MANAGER 2 Decisions Affect Stock Prices? 12
Stakeholders 2 It’s All about Cash Flows 2
Building Intuition: Cash Flows Matter Most to Inves- 1.5 AGENCY CONFLICTS: SEPARATION OF
tors 4 Three Fundamental Decisions in Financial OWNERSHIP AND CONTROL 13
Management 4 Building Intuition: Sound Invest-
ments are Those Where the Value of the Benefits Ownership and Control 14 Agency
Exceeds Their Cost 5 Building Intuition: Financing Relationships 14 Do Managers Really Want
Decisions Affect the Value of the Firm 5 to Maximize Stock Price? 14 Aligning the
Interests of Management and Stockholders 14
1.2 FORMS OF BUSINESS ORGANIZATION 6 Sarbanes-Oxley and Other Regulatory
Sole Proprietorships 6 Partnerships 7 Reforms 16
Corporations 7 Hybrid Forms of Business
Organization 8 1.6 THE IMPORTANCE OF ETHICS IN BUSINESS 18

1.3 MANAGING THE FINANCIAL FUNCTION 9 Business Ethics 18 Are Business Ethics Different
Organizational Structure 9 Positions Reporting from Everyday Ethics? 18 Types of Ethical Conflicts
to the CFO 10 External Auditors 10 in Business 19 The Importance of an Ethical Busi-
The Audit Committee 10 The Compliance ness Culture 20 Serious Consequences 20
and Ethics Director 10
Summary of Learning Objectives • Self-Study
1.4 THE GOAL OF THE FIRM 11 Problems • Solutions to Self-Study Problems •
What Should Management Maximize? 11 Critical Thinking Questions • Questions and Problems •
Why Not Maximize Profits? 11 Sample Test Problems

PART 2 FOUNDATIONS

2C H A P T E R 2.2 DIRECT FINANCING 27 Investment Banks

The Financial System and the Level of A Direct Market Transaction 28
Interest Rates 24 and Direct Financing 28

2.1 THE FINANCIAL SYSTEM 25 How Funds Flow 2.3 TYPES OF FINANCIAL MARKETS 30

The Financial System at Work 26 Primary and Secondary Markets 30
through the Financial System 26 Exchanges and Over-the-Counter Markets 31
Money and Capital Markets 31

xxvi CONTENTS

Public and Private Markets 31 Futures and Options 3.8 FEDERAL INCOME TAX 71
Markets 32 Corporate Income Tax Rates 72 Average versus
Marginal Tax Rates 72 Unequal Treatment of Divi-
2.4 MARKET EFFICIENCY 33 dends and Interest Payments 73
Efficient Market Hypotheses 33
Summary of Learning Objectives • Summary of
2.5 FINANCIAL INSTITUTIONS AND INDIRECT Key Equations • Self-Study Problems • Solutions
FINANCING 34 to Self-Study Problems • Critical Thinking Questions •
Questions and Problems • Sample Test Problems
Indirect Market Transactions 35 Financial Institutions
and Their Services 35 Corporations and the Financial
System 36

2.6 THE DETERMINANTS OF INTEREST 4C H A P T E R
RATE LEVELS 38
Analyzing Financial Statements 81
The Real Rate of Interest 38 Loan Contracts
and Inflation 40 The Fisher Equation and 4.1 BACKGROUND FOR FINANCIAL STATEMENT
Inflation 40 Cyclical and Long-Term Trends ANALYSIS 82
in Interest Rates 42
Perspectives on Financial Statement
Summary of Learning Objectives • Summary of Key Equations • Analysis 82 Guidelines for Financial
Self-Study Problems • Solutions to Self-Study Problems • Statement Analysis 83
Critical Thinking Questions • Questions and Problems •
Sample Test Problems 4.2 COMMON-SIZE FINANCIAL
STATEMENTS 84
3C H A P T E R Common-Size
Common-Size Balance Sheets 84
Financial Statements, Cash Flows, Income Statements 85
and Taxes 48
4.3 FINANCIAL RATIOS AND FIRM PERFORMANCE 86
3.1 FINANCIAL STATEMENTS AND ACCOUNTING
PRINCIPLES 49 Why Ratios Are Better Measures 86 Short-Term
Liquidity Ratios 87 Efficiency Ratios 89
The Annual Report 49 Generally Accepted Ac- Leverage Ratios 93 Profitability Ratios 97
counting Principles 50 Fundamental Accounting Market-Value Indicators 100 Concluding
Principles 50 International GAAP 51 Illustrative Comments on Ratios 101
Company: Diaz Manufacturing 51
4.4 THE DUPONT SYSTEM: A DIAGNOSTIC
3.2 THE BALANCE SHEET 52 Long-Term Assets TOOL 101

Current Assets and Liabilities 53 An Overview of the DuPont System 101 The ROA
and Liabilities 54 Equity 55 Equation 101 The ROE Equation 103 The
DuPont Equation 103 Applying the DuPont
3.3 MARKET VALUE VERSUS BOOK VALUE 57 System 104 Is Maximizing ROE an Appropriate
Goal? 104
A More Informative Balance Sheet 57 A Market-
Value Balance Sheet 58 4.5 SELECTING A BENCHMARK 106

3.4 THE INCOME STATEMENT AND THE STATEMENT Trend Analysis 106 Industry Analysis 106 Peer
OF RETAINED EARNINGS 60 Group Analysis 106

The Income Statement 60 The Statement of 4.6 USING FINANCIAL RATIOS 108
Retained Earnings 63
Performance Analysis of Diaz Manufacturing 108
3.5 THE STATEMENT OF CASH FLOWS 63 Limitations of Financial Statement Analysis 111
Sources and Uses of Cash 63

3.6 TYING THE FINANCIAL STATEMENTS Summary of Learning Objectives • Summary of
TOGETHER 66 Key Equations • Self-Study Problems • Solutions
to Self-Study Problems • Critical Thinking Questions •
3.7 CASH FLOWS TO INVESTORS 67 Questions and Problems • Sample Test Problems

Net Income versus the Cash Flow to Investors 67 ETHICS CASE: A Sad Tale: The Demise of
Cash Flow To Investors: Putting It All Together 70 Arthur Andersen 122

CONTENTS xxvii

PART 3 VALUATION OF FUTURE CASH FLOWS AND RISK

5C H A P T E R 6.4 THE EFFECTIVE ANNUAL INTEREST RATE 185
Why the Confusion? 185 Calculating the
The Time Value of Money 124 Effective Annual Interest Rate 185 Comparing
Interest Rates 186 Consumer Protection Acts
5.1 THE TIME VALUE OF MONEY 125 and Interest Rate Disclosure 187 The Appropriate
Interest Rate Factor 188
Consuming Today or Tomorrow 125 Building
Intuition: The Value of Money Changes with Time 126 Summary of Learning Objectives • Summary of Key
Time Lines as Aids to Problem Solving 126 Equations • Self-Study Problems • Solutions to Self-Study
Financial Calculator 127 Problems • Critical Thinking Questions • Questions and
Problems • Sample Test Problems
5.2 FUTURE VALUE AND COMPOUNDING 127
APPENDIX: Deriving the Formula for the
Single-Period Investment 127 Two-Period Present Value of an Ordinar y Annuity 196
Investment 128 The Future Value Equation 129 Problem 197
The Future Value Factor 131 Applying the ETHICS CASE: Buy It on Credit and Be True to
Future Value Formula 132 Building Intuition: Your School 198
Compounding Drives Much of the Earnings on
Long-Term Investments 134 Calculator Tips for 7C H A P T E R
Future Value Problems 137
Risk and Return 200
5.3 PRESENT VALUE AND DISCOUNTING 140
7.1 RISK AND RETURN 201
Single-Period Investment 140 Multiple-Period Building Intuition: More Risk Means a Higher Expected
Investment 141 The Present Value Equation 142 Return 202
Future and Present Value Equations Are the Same 142
Applying the Present Value Formula 142 The Relations 7.2 QUANTITATIVE MEASURES OF RETURN 202
among Time, the Discount Rate, and Present Value 144 Holding Period Returns 202 Expected Returns 203
Calculator Tips for Present Value Problems 145
Future Value versus Present Value 146 7.3 THE VARIANCE AND STANDARD DEVIATION AS
MEASURES OF RISK 207
5.4 ADDITIONAL CONCEPTS AND Calculating the Variance and Standard Deviation 207
APPLICATIONS 147 Interpreting the Variance and Standard Deviation 208
Historical Market Performance 211
Finding the Interest Rate 148 Finding How Many
Periods It Takes an Investment to Grow a Certain 7.4 RISK AND DIVERSIFICATION 214
Amount 149 The Rule of 72 150 Compound Single-Asset Portfolios 215 Portfolios with More
Growth Rates 150 Concluding Comments 152 Than One Asset 217 Building Intuition: Diversified
Portfolios are Less Risky 223 The Limits of Diversifi-
Summary of Learning Objectives • Summary of Key Equations • cation 223
Self-Study Problems • Solutions to Self-Study Problems •
Critical Thinking Questions • Questions and Problems • 7.5 SYSTEMATIC RISK 224
Sample Test Problems Why Systematic Risk Is All That Matters 224
Building Intuition: Systematic Risk Is the Risk That
6C H A P T E R Matters 224 Measuring Systematic Risk 225

Discounted Cash Flows and Valuation 159 7.6 COMPENSATION FOR BEARING SYSTEMATIC
RISK 227
6.1 MULTIPLE CASH FLOWS 160 Present
7.7 THE CAPITAL ASSET PRICING MODEL 228
Future Value of Multiple Cash Flows 160 The Security Market Line 228 The Capital Asset
Value of Multiple Cash Flows 163 Pricing Model andPortfolio Returns 230

6.2 LEVEL CASH FLOWS: ANNUITIES AND Summary of Learning Objectives • Summary of Key
PERPETUITIES 167 Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and
Present Value of an Annuity 167 Future Value
of an Annuity 177 Perpetuities 179
Annuities Due 181

6.3 CASH FLOWS THAT GROW AT A CONSTANT
RATE 183

xxviii CONTENTS

8C H A P T E R 9C H A P T E R

Bond Valuation and the Structure of Stock Valuation 270
nterest Rates 238
9.1 THE MARKET FOR STOCKS 271
8.1 CORPORATE BONDS 239
Secondary Markets 271 Secondary Markets and
Market for Corporate Bonds 239 Bond Price Infor- Their Efficiency 272 Stock Market Indexes 274
mation 240 Types of Corporate Bonds 240 Reading the Stock Market Listings 274
Common and Preferred Stock 275 Preferred Stock:
8.2 BOND VALUATION 241 Debt or Equity? 276

The Bond Valuation Formula 242 Calculator Tip: 9.2 COMMON STOCK VALUATION 276
Bond Valuation Problems 243 Par, Premium,
and Discount Bonds 244 Semiannual A One-Period Model 277 A Perpetuity Model 278
Compounding 246 Zero Coupon Bonds 246 The General Dividend Valuation Model 279 The
Growth Stock Pricing Paradox 280
8.3 BOND YIELDS 248
9.3 STOCK VALUATION: SOME SIMPLIFYING
Yield to Maturity 249 Effective Annual Yield 250 ASSUMPTIONS 281
Realized Yield 252
Zero-Growth Dividend Model 281 Constant-Growth
8.4 INTEREST RATE RISK 252 Dividend Model 281 Computing Future Stock
Prices 284 The Relationship between R and g 286
Bond Theorems 253 Bond Theorem Mixed (Supernormal) Growth Dividend Model 286
Applications 255
9.4 VALUING PREFERRED STOCK 290
8.5 THE STRUCTURE OF INTEREST RATES 255
Preferred Stock with a Fixed Maturity 290
Marketability 255 Call Provision 256 Default Preferred Stock with No Maturity 291
Risk 256 The Term Structure of Interest Rates 258

Summary of Learning Objectives • Summary of Key Summary of Learning Objectives • Summary of Key
Equations • Self-Study Problems • Solutions to Self-Study Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and Problems • Critical Thinking Questions • Questions and
Problems • Sample Test Problems Problems • Sample Test Problems

ETHICS CASE: The Subprime Mortgage Market ETHICS CASE: Insider Trading: Have I Got a
Meltdown: How Did It Happen? 267 S to ck Ti p for You ! 2 9 9

PART 4 CAPITAL BUDGETING DECISIONS

1 0CHAPTER 10.3 THE PAYBACK PERIOD 313
Computing the Payback Period 313 How the
The Fundamentals of Capital Payback Period Performs 315 Discounted Payback
Budgeting 301 Period 316 Evaluating the Payback Rule 317

10.1 AN INTRODUCTION TO CAPITAL 10.4 THE ACCOUNTING RATE OF RETURN 318
BUDGETING 302
10.5 INTERNAL RATE OF RETURN 318
The Importance of Capital Budgeting 302 The
Capital Budgeting Process 303 Sources of Informa- Calculating the IRR 319 When the IRR and NPV
tion 304 Classification of Investment Projects 304 Methods Agree 321 When the NPV and IRR Meth-
Basic Capital Budgeting Terms 305 Building ods Disagree 322 Modified Internal Rate of Return
Intuition: Investment Decisions Have Opportunity (MIRR) 325 IRR versus NPV: A Final Comment 327
Costs 305
10.6 CAPITAL BUDGETING IN PRACTICE 328
10.2 NET PRESENT VALUE 306
Practitioners’ Methods of Choice 329 Postaudit and
Valuation of Real Assets 306 NPV—The Basic Ongoing Reviews 329
Concept 306 NPV and Value Creation 307
Framework for Calculating NPV 307 Net Present Summary of Learning Objectives • Summary of Key
Value Techniques 309 Concluding Comments on Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and

CONTENTS xxix

1 1CHAPTER Building Intuition: Revenue Changes Drive Profit
Volatility Through Operating Leverage 390
Cash Flows and Capital Budgeting 341
12.3 BREAK-EVEN ANALYSIS 391
11.1 CALCULATING PROJECT CASH FLOWS 342
Building Intuition: Capital Budgeting is Forward Pretax Operating Cash Flow Break-Even 391
Looking 342 Incremental After-Tax Free Cash Accounting Break-Even 393
Flows 343 The FCF Calculation 343 Building
Intuition: Incremental After-Tax Free Cash Flows Are What 12.4 RISK ANALYSIS 395 Scenario Analysis 396
Stockholders Care About in Capital Budgeting 344
Cash Flows from Operations 345 Cash Flows As- Sensitivity Analysis 395
sociated with Capital Expenditures and Net Working Simulation Analysis 397
Capital 345 The FCF Calculation: An Example 346
FCF versus Accounting Earnings 349 12.5 INVESTMENT DECISIONS WITH CAPITAL
RATIONING 398
11.2 ESTIMATING CASH FLOWS IN PRACTICE 350
Five General Rules for Incremental After-Tax Capital Rationing in a Single Period 399
Free Cash Flow Calculations 350 Nominal Capital Rationing across Multiple Periods 401
versus Real Cash Flows 353 Tax Rates and
Depreciation 355 Computing the Terminal-Year Summary of Learning Objectives • Summary of Key
FCF 359 Expected Cash Flows 362 Equations • Self-Study Problems • Solutions to Self-Study
Building Intuition: We Discount Expected Cash Flows Problems • Critical Thinking Questions • Questions and
in an NPV Analysis 362 Problems • Sample Test Problems

11.3 FORECASTING FREE CASH FLOWS 363 1 3CHAPTER
Cash Flows from Operations 363 Cash Flows
Associated with Capital Expenditures and Net Working The Cost of Capital 409
Capital 364
13.1 THE FIRM’S OVERALL COST OF CAPITAL 410
11.4 SPECIAL CASES (OPTIONAL) 365 The Finance Balance Sheet 411 Building
Projects with Different Lives 365 When to Harvest Intuition: The Market Value of a Firm’s Assets
an Asset 367 When to Replace an Existing Equals the Market Value of the Claims on Those
Asset 368 The Cost of Using an Existing Asset 369 Assets 412 How Firms Estimate Their Cost
of Capital 413 Building Intuition: A Firm’s
Summary of Learning Objectives • Summary of Key Cost of Capital Is a Weighted Average of All of Its
Equations • Self-Study Problems • Solutions to Self-Study Financing Costs 414
Problems • Critical Thinking Questions • Questions and
Problems • Sample Test Problems 13.2 THE COST OF DEBT 415
Key Concepts for Estimating the Cost of Debt 415
ETHICS CASE: Unilever’s Sustainable Building Intuition: The Current Cost of Long-Term
Living Plan 378 Debt Is What Matters When Calculating WACC 416
Estimating the Current Cost of a Bond or
1 2CHAPTER an Outstanding Loan 416 Taxes and the
Cost of Debt 418 Estimating the Cost of Debt
Evaluating Project Economics and for a Firm 418
Capital Rationing 380
13.3 THE COST OF EQUITY 421
12.1 VARIABLE COSTS, FIXED COSTS, AND Common Stock 421 Preferred Stock 426
PROJECT RISK 381
Cost Structure and Sensitivity of EBITDA to Revenue 13.4 USING THE WACC IN PRACTICE 428
Changes 382 Cost Structure and Sensitivity of EBIT Calculating WACC: An Example 428
to Revenue Changes 385 Building Intuition: High Limitations of WACC as a Discount Rate for
Fixed Costs Mean Larger Fluctuations in Cash Flows and Evaluating Projects 430 Alternatives to Using
Profits 385 WACC for Evaluating Projects 433

12.2 CALCULATING OPERATING LEVERAGE 388 Summary of Learning Objectives • Summary of Key
Degree of Pretax Cash Flow Operating Leverage 389 Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and

xxx CONTENTS

PART 5 WORKING CAPITAL MANAGEMENT AND
FINANCING DECISIONS

1 4CHAPTER Less Risky Than Unseasoned Securities 481
Investment Banking Services 481 Origination 481
Working Capital Management 441 Underwriting 482 Distribution 483
The Proceeds 483
14.1 WORKING CAPITAL BASICS 442
Working 15.4 IPO PRICING AND COST 485
Working Capital Terms and Concepts 443
Capital Accounts and Trade-Offs 444 The Underpricing Debate 485 IPOs Are
Consistently Underpriced 485 The Cost of an
14.2 THE OPERATING AND CASH CONVERSION IPO 486
CYCLES 445
15.5 GENERAL CASH OFFER BY A PUBLIC
Operating Cycle 446 Cash Conversion Cycle 448 COMPANY 488

14.3 WORKING CAPITAL MANAGEMENT Competitive versus Negotiated Sale 489 The Cost
STRATEGIES 450 of a General Cash Offer 490

Flexible Current Asset Management Strategy 450 15.6 PRIVATE MARKETS AND BANK LOANS 491
Restrictive Current Asset Management Strategy 450
The Working Capital Trade-Off 451 Private versus Public Markets 492 Private Place-
ments 492 Private Equity Firms 493 Private
14.4 ACCOUNTS RECEIVABLE 452 Investments in Public Equity 494 Commercial Bank
Terms of Sale 452 Aging Accounts Receivable 453 Lending 494 Concluding Comments on Funding
the Firm 496
14.5 INVENTORY MANAGEMENT 455

Economic Order Quantity 455 Just-in-Time Inven- Summary of Learning Objectives • Summary of Key
tory Management 456 Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and
14.6 CASH MANAGEMENT AND BUDGETING 456 Problems • Sample Test Problems

Reasons for Holding Cash 456 Cash Collection 457 ETHICS CASE: Profiting from Death: “Jani-
tor’s Insurance” 502
14.7 FINANCING WORKING CAPITAL 458
1 6CHAPTER
Strategies for Financing Working Capital 458
Financing Working Capital in Practice 460 Capital Structure Policy 504
Sources of Short-Term Financing 461

Summary of Learning Objectives • Summary of Key 16.1 CAPITAL STRUCTURE AND FIRM VALUE 505
Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and The Optimal Capital Structure 505 Building Intuition:
Problems • Sample Test Problems The Optimal Capital Structure Minimizes the Cost of
Financing a Firm’s Activities 506 The Modigliani
1 5CHAPTER and Miller Propositions 506 Building Intuition:
Capital Structure Choices Do Not Affect Firm Value If
How Firms Raise Capital 472 They Do Not Affect the Value of the Free Cash Flows to
Investors 506 Building Intuition: The Cost of Equity
15.1 BOOTSTRAPPING 473 Increases With Financial Leverage 510

How New Businesses Get Started 473 Initial Fund- 16.2 THE BENEFITS AND COSTS OF USING
ing of the Firm 474 DEBT 514

15.2 VENTURE CAPITAL 474 The Benefits of Debt 514 The Costs of Debt 520
Building Intuition: People Behave Differently toward a
The Venture Capital Industry 474 Why Venture Firm in Financial Distress, and This Increases Bankruptcy
Capital Funding Is Different 475 The Venture Capi- Costs 522
tal Funding Cycle 476 Venture Capitalists Provide
More Than Financing 479 The Cost of Venture 16.3 TWO THEORIES OF CAPITAL STRUCTURE 526
Capital Funding 479
The Trade-Off Theory 526 The Pecking Order
15.3 INITIAL PUBLIC OFFERING 479 Theory 526 The Empirical Evidence 527

Advantages and Disadvantages of Going Public 480 16.4 PRACTICAL CONSIDERATIONS IN CHOOSING A

CONTENTS xxxi

Summary of Learning Objectives • Summary of Key 17.3 DIVIDENDS AND FIRM VALUE 554
Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and Benefits and Costs of Dividends 555 Stock Price
Problems • Sample Test Problems Reactions to Dividend Announcements 557
Dividends versus Stock Repurchases 558
APPENDIX: Leasing 535
17.4 STOCK DIVIDENDS AND STOCK
1 7CHAPTER SPLITS 560

Dividends, Stock Repurchases, and Stock Dividends 560 Stock Splits 561 Reasons
Payout Policy 545 for Stock Dividends and Splits 561

17.1 DIVIDENDS 546 17.5 SETTING A DIVIDEND PAYOUT 562
Building Intuition: Dividends Reduce the Stockholders’
Investment in a Firm 546 Types of Dividends 547 What Managers Tell Us 563 Practical Considerations
The Dividend Payment Process 548 Building Intuition: in Setting a Dividend Payout 563
Dividend Announcements Send Signals to Investors 549
Summary of Learning Objectives • Self-Study Problems •
17.2 STOCK REPURCHASES 551 Solutions to Self-Study Problems • Critical Thinking
How Stock Repurchases Differ from Dividends 551 Questions • Questions and Problems • Sample Test
How Stock Is Repurchased 553 Problems

PART 6 BUSINESS FORMATION, VALUATION, AND
FINANCIAL PLANNING

1 8CHAPTER 1 9CHAPTER

Business Formation, Growth, and Financial Planning and Forecasting 606
Valuation 569
19.1 FINANCIAL PLANNING 607
18.1 STARTING A BUSINESS 570 The Planning Documents 607 Building Intuition:
A Firm’s Strategy Drives Its Business Decisions 609
Making the Decision to Proceed 571 Choosing Concluding Comments 610
the Right Organizational Form 571 Financial
Considerations 574 19.2 FINANCIAL PLANNING MODELS 610
The Sales Forecast 611 Building a Financial Planning
18.2 THE ROLE OF THE BUSINESS PLAN 578 Model 611 A Simple Planning Model 613

Why Business Plans Are Important 578 19.3 A BETTER FINANCIAL PLANNING MODEL 616
The Key Elements of a Business Plan 579 The Blackwell Sales Company 616 The Income
Statement 616 The Balance Sheet 617
18.3 VALUING A BUSINESS 580 The Preliminary Pro Forma Balance Sheet 619
The Final Pro Forma Balance Sheet 621
Fundamental Business Valuation Principles 580
Building Intuition: The Value of a Business Is 19.4 BEYOND THE BASIC PLANNING MODELS 623
Specific to a Point in Time 580 Building Improving Financial Planning Models 623
Intuition: The Value of a Business Is Not the
Same to All Investors 581 Business Valuation 19.5 MANAGING AND FINANCING GROWTH 625
Approaches 581 External Funding Needed 625 A Graphical
View of Growth 628 The Sustainable Growth
18.4 IMPORTANT ISSUES IN VALUATION 594 Rate 629 Growth Rates and Profits 631
Growth As a Planning Goal 631
Public versus Private Companies 594
Young (Rapidly Growing) versus Mature Companies 595
Controlling Interest versus Minority Interest 596
Key People 596

Summary of Learning Objectives • Summary of Key Summary of Learning Objectives • Summary of Key
Equations • Self-Study Problems • Solutions to Self-Study Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and Problems • Critical Thinking Questions • Questions and

xxxii CONTENTS

PART 7 OPTIONS IN CORPORATE FINANCE AND
INTERNATIONAL DECISIONS

2 0CHAPTER 2 1CHAPTER

Options and Corporate Finance 641 International Financial Management 671

20.1 FINANCIAL OPTIONS 643 21.1 INTRODUCTION TO INTERNATIONAL
FINANCIAL MANAGEMENT 672
Call Options 643 Put Options 644 Globalization of the World Economy 672 The Rise
American, European, and Bermudan Options 644 of Multinational Corporations 673 Factors Affect-
More on the Shapes of Option Payoff Functions 645 ing International Financial Management 673 Goals
Building Intuition: Payoff Functions for Options Are of International Financial Management 675 Basic
Not Linear 646 Principles Remain the Same 676 Building Intuition:
The Basic Principles of Finance Apply No Matter Where
20.2 OPTION VALUATION 646 You Do Business 676

Limits on Option Values 646 Variables That Affect 21.2 FOREIGN EXCHANGE MARKETS 677
Option Values 648 The Binomial Option Pricing Market Structure and Major Participants 677 For-
Model 649 Put-Call Parity 652 Valuing Options eign Exchange Rates 677 The Equilibrium Exchange
Associated with the Financial Securities That Rate 679 Foreign Currency Quotations 680
Firms Issue 653
21.3 INTERNATIONAL CAPITAL BUDGETING 685
20.3 REAL OPTIONS 655 Determining Cash Flows 685 Exchange Rate Risk 686
Country Risk 686 The Barcelona Example 687
Options to Defer Investment 655 Options to
Make Follow-On Investments 656 Options to 21.4 GLOBAL MONEY AND CAPITAL MARKETS 689
Change Operations 656 Options to Abandon The Emergence of the Euromarkets 689
Projects 657 Concluding Comments on NPV The Eurocurrency Market 689 The Eurocredit
Analysis and Real Options 657 Market 690 International Bond Markets 690

20.4 AGENCY COSTS 658 21.5 INTERNATIONAL BANKING 692
Risks Involved in International Bank Lending 692
Agency Costs of Debt 659 Agency Costs of Eurocredit Bank Loans 693
Equity 660
Summary of Learning Objectives • Summary of Key
20.5 OPTIONS AND RISK MANAGEMENT 662 Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and
Summary of Learning Objectives • Summary of Key Problems • Sample Test Problems
Equations • Self-Study Problems • Solutions to Self-Study
Problems • Critical Thinking Questions • Questions and
Problems • Sample Test Problems

ETHICS CASE: Compensation—How Much Is
Enough? 669

The Financial

1Manager and
the Firm

Learning Objectives

Ron Buskirk/Alamy

O 1 Identify the key financial decisions facing the
financial manager of any business firm.

n October 7, 2009, Anheuser-Busch InBev managers an-
nounced that they had reached an agreement to sell their company’s 2 Identify the basic forms of business organi-
zation in the United States and their respec-
Busch Entertainment Corporation subsidiary to the Blackstone CHAPTER ONE
tive strengths and weaknesses.
Group in a $2.7 billion leveraged buyout—a transaction in which

the purchaser uses a lot of debt to pay for the acquisition. Busch 3 Describe the typical organization of the

Entertainment is the second largest operator of theme parks in the financial function in a large corporation.

United States. The parks they operate include the SeaWorld parks in 4 Explain why maximizing the current value of
Florida, California, and Texas and the Busch Garden amusement
the firm’s stock is the appropriate goal for
parks in Florida and Virginia.
management.
How did the Anheuser-Busch InBev and Blackstone Group

managers arrive at the $2.7 billion price tag for Busch Entertain- 5 Discuss how agency conflicts affect the goal

ment, and why did the managers of Blackstone, a global private of maximizing stockholder value.

equity group, decide to purchase the theme parks? Surely, the 6 Explain why ethics is an appropriate topic in

Blackstone managers did not plan to lose money when they the study of corporate finance.

agreed to the price; they thought that the investment would be

very profitable. The Busch Entertainment parks complement sev-

eral businesses that were already owned by Blackstone, including

the Legoland theme parks, Universal Orlando, and the Madame Tussaud’s wax museums.

By taking advantage of their operational experience to increase the efficiency of the Busch

Entertainment parks and by using a great deal of debt financing, the new owners planned

to increase the amount of cash flow the Busch Entertainment parks would generate and

earn high returns for their investors.

Investors in leveraged buyouts like the Busch Entertainment transaction use many of the

concepts covered in this chapter and elsewhere in this book to create the most value possible.

Managers of leveraged buyout firms are paid in a way that provides them with strong incentives

to focus on value creation. They create value by investing in companies only when the benefits

2 CHAPTER 1 I The Financial Manager and the Firm

exceed the cost, managing the assets of the companies they buy as efficiently as possible, and
financing those companies with the least expensive combination of debt and equity. This chap-
ter introduces you to the key financial aspects of these activities, and the remainder of the book
fills in many of the details.

CHAPTER PREVIEW We open this chapter by discussing the three major types of
decisions that a financial manager makes. We then describe
This book provides an introduction to corporate finance. In it common forms of business organization. After next discuss-
we focus on the responsibilities of the financial manager, who ing the major responsibilities of the financial manager, we
oversees the accounting and treasury functions and sets the explain why maximizing the value of the firm’s stock is an ap-
overall financial strategy for the firm. We pay special atten- propriate goal for a financial manager. We go on to describe
tion to the financial manager’s role as a decision maker. To the conflicts of interest that can arise between stockholders
that end, we emphasize the mastery of fundamental finance and managers and the mechanisms that help align the inter-
concepts and the use of a set of financial tools, which will re- ests of these two groups. Finally, we discuss the importance
sult in sound financial decisions that create value for stock- of ethical conduct in business.
holders. These financial concepts and tools apply not only to
business organizations but also to other venues, such as gov-
ernment entities, not-for-profit organizations, and sometimes
even your own personal finances.

1.1 THE ROLE OF THE FINANCIAL MANAGER

LEARNING OBJECTIVE The financial manager is responsible for making decisions that are in the best interests of the
firm’s owners, whether the firm is a start-up business with a single owner or a billion-dollar
wealth corporation owned by thousands of stockholders. The decisions made by the financial man-
he economic value of the ager or owner should be one and the same. In most situations this means that the financial
assets someone possesses manager should make decisions that maximize the value of the owners’ stock. This helps
maximize the owners’ wealth. Our underlying assumption in this book is that most people
takeholder who invest in businesses do so because they want to increase their wealth. In the following
anyone other than an discussion, we describe the responsibilities of the financial manager in a new business in
owner (stockholder) with a order to illustrate the types of decisions that such a manager makes.
laim on the cash flows of a
firm, including employees, Stakeholders
uppliers, creditors, and the
government Before we discuss the new business, you may want to look at Exhibit 1.1, which shows the cash
flows between a firm and its owners (in a corporation, the stockholders) and various stakeholders.
productive assets A stakeholder is someone other than an owner who has a claim on the cash flows of the firm:
he tangible and intangible managers, who want to be paid salaries and performance bonuses; other employees, who want
assets a firm uses to generate to be paid wages; suppliers, who want to be paid for goods or services; the government, which
wants the firm to pay taxes; and creditors, who want to be paid interest and principal. Stakehold-
ers may have interests that differ from those of the owners. When this is the case, they may exert
pressure on management to make decisions that benefit them. We will return to these types of
conflicts of interest later in the book. For now, though, we are primarily concerned with the
overall flow of cash between the firm and its stockholders and stakeholders.

It’s All about Cash Flows

To produce its products or services, a new firm needs to acquire a variety of assets. Most will be
long-term assets, which are also known as productive assets. Productive assets can be tangible

1.1 The Role of the Financial Manager 3

The Firm Stakeholders and EXHIBIT 1.1
Stockholders Cash Flows Between the
Firm and Its Stakeholders
A Firm’s Cash paid as Managers and Owners (Stockholders)
management wages and salaries and other
Cash flows are generated invests in assets employees A. Making business decisions
by productive assets is all about cash flows,
through the sale of • Current assets because only cash can be
goods and services used to pay bills and buy new
Cash Cash paid to Suppliers assets. Cash initially flows into
Inventory suppliers Government the firm as a result of the sale
Accounts of goods or services. The firm
receivable Cash paid Creditors uses these cash inflows in a
• Productive assets as taxes number of ways: to pay wages
Plant and salaries, to buy supplies,
Equipment Cash paid as to pay taxes, and to repay
Buildings interest and principal creditors.
Technology
Patents B. Any cash that is left over
(residual cash flows) can be
B Stockholders reinvested in the business
Residual cash flows or paid as dividends to
stockholders.

Cash flows reinvested Dividends paid to
in business stockholders

as patents, trademarks, technical expertise, or other types of intellectual capital. Regardless of residual cash flows
the type of asset, the firm tries to select assets that will generate the greatest cash flows. The the cash remaining after a firm
decision-making process through which the firm purchases long-term productive assets is has paid operating expenses
called capital budgeting, and it is one of the most important decision processes in a firm. and what it owes creditors and
in taxes; can be paid to the
Once the firm has selected its productive assets, it must raise money to pay for them. owners as a cash dividend or
Financing decisions are concerned with the ways in which firms obtain and manage long-term reinvested in the business
financing to acquire and support their productive assets. There are two basic sources of funds:
debt and equity. Every firm has some equity because equity represents ownership in the firm.
It consists of capital contributions by the owners plus cash flows that have been reinvested in
the firm. In addition, most firms borrow from a bank or issue some type of long-term debt to
finance productive assets.

After the productive assets have been purchased and the business is operating, the firm will
try to produce products at the lowest possible cost while maintaining quality. This means buy-
ing raw materials at the lowest possible cost, holding production and labor costs down, keeping
management and administrative costs to a minimum, and seeing that shipping and delivery
costs are competitive. In addition, the firm must manage its day-to-day finances so that it will
have sufficient cash on hand to pay salaries, purchase supplies, maintain inventories, pay taxes,
and cover the myriad of other expenses necessary to run a business. The management of cur-
rent assets, such as money owed by customers who purchase on credit, inventory, and current
liabilities, such as money owed to suppliers, is called working capital management.1

A firm generates cash flows by selling the goods and services it produces. A firm is
successful when these cash inflows exceed the cash outflows needed to pay operating expenses,
creditors, and taxes. After meeting these obligations, the firm can pay the remaining cash,
called residual cash flows, to the owners as a cash dividend, or it can reinvest the cash in the
business. The reinvestment of residual cash flows back into the business to buy more produc-
tive assets is a very important concept. If these funds are invested wisely, they provide the foun-
dation for the firm to grow and provide larger residual cash flows in the future for the owners.
The reinvestment of cash flows (earnings) is the most fundamental way that businesses grow in
size. Exhibit 1.1 illustrates how the revenue generated by productive assets ultimately becomes
residual cash flows.

1From accounting, current assets are assets that will be converted into cash within a year and current liabilities are

4 CHAPTER 1 I The Financial Manager and the Firm

BUILDING CASH FLOWS MATTER MOST TO INVESTORS A firm is unprofitable when it fails to generate
Cash is what investors ultimately care about sufficient cash inflows to pay operating expenses, cred-
itors, and taxes. Firms that are unprofitable over time

INTUITION when making an investment. The value of any will be forced into bankruptcy by their creditors if the
owners do not shut them down first. In bankruptcy the
asset—stocks, bonds, or a business—is de- company will be reorganized or the company’s assets
termined by the cash flows it is expected to will be liquidated, whichever is more valuable. If the
generate in the future. To understand this concept, just consider company is liquidated, creditors are paid in a priority
how much you would pay for an asset from which you could nev- order according to the structure of the firm’s financial
er expect to obtain any cash flows. Buying such an asset would contracts and prevailing bankruptcy law. If anything is
be like giving your money away. It would have a value of exactly left after all creditor and tax claims have been satisfied,
zero. Conversely, as the expected cash flows from an investment which usually does not happen, the remaining cash, or
increase, you would be willing to pay more and more for it.

bankruptcy residual value, is distributed to the owners.

egally declared inability of an Three Fundamental Decisions in Financial Management
ndividual or a company to pay

ts creditors Based on our discussion so far, we can see that financial managers are concerned with three

fundamental decisions when running a business:

1. Capital budgeting decisions: Identifying the productive assets the firm should buy.

2. Financing decisions: Determining how the firm should finance or pay for assets.

3. Working capital management decisions: Determining how day-to-day financial matters should
be managed so that the firm can pay its bills, and how surplus cash should be invested.

Exhibit 1.2 shows the impact of each decision on the firm’s balance sheet. We briefly introduce
each decision here and discuss them in greater detail in later chapters.

Capital Budgeting Decisions

A firm’s capital budget is simply a list of the productive (capital) assets management
wants to purchase over a budget cycle, typically one year. The capital budgeting deci-
sion process addresses which productive assets the firm should purchase and how much
money the firm can afford to spend. As shown in Exhibit 1.2, capital budgeting decisions

EXHIBIT 1.2 Balance Sheet
How the Financial Manager’s
Decisions Affect the Balance Assets Working capital Liabilities and Equity
Sheet management decisions
Current assets deal with day-to-day financial Current liabilities
Financial managers are (including cash, matters and affect current (including short term
concerned with three inventory, and assets, current liabilities, and
fundamental types of decisions: accounts receivable) net working capital. debt and
capital budgeting decisions, accounts payable)
financing decisions, and Long-term
working capital management productive assets Net working capital—the Long-term debt
decisions. Each type of (may be tangible difference between current (debt with a
decision has a direct and assets and current liabilities
important effect on the firm’s or intangible) maturity of over
balance sheet—in other words, Capital budgeting one year)
on the firm’s profitability. decisions
determine what long-term
productive assets the firm
will purchase.

Financing decisions Stockholders’
determine the firm’s equity
capital structure—the
combination of long-term
debt and equity that will
be used to finance the
firm’s long-term productive
assets and net working
capital.

1.1 The Role of the Financial Manager 5

affect the asset side of the balance sheet and are concerned with a firm’s long-term invest-

ments. Capital budgeting decisions, as we mentioned earlier, are among management’s

most important decisions. Over the long run, they have a large impact on the firm’s

success or failure. The reason is twofold. First, capital (productive) assets generate most

of the cash flows for the firm. Second, capital assets are long term in nature. Once they

are purchased, the firm owns them for a long time, and they may be hard to sell without

taking a financial loss.

The fundamental question in capital budgeting is this: Which productive assets should

the firm purchase? A capital budgeting decision may be as simple as a movie theater’s deci-

sion to buy a popcorn machine or as complicated as Boeing’s decision to invest more than $6

billion to design and build the 787 Dreamliner passenger jet. Capital investments may also in-

volve the purchase of an entire business, such as IBM’s purchase of PricewaterhouseCoopers’

(PwC) management consulting practice.

Regardless of the project, a good capital budgeting decision is one in which the benefits

are worth more to the firm than the cost of the asset. For example, IBM paid around $3.5

billion for PwC’s consulting practice. Presumably, IBM expects that the investment will pro-

duce a stream of cash flows worth more than that. Suppose IBM estimates that in terms of the

current market value, the future cash flows from the PwC acquisition are worth $5 billion. Is

the acquisition a good deal for IBM? The answer is yes because the value of the expected

cash flow benefits from the acquisition exceeds the cost by $1.5 billion ($5.0 billion Ϫ $3.5

billion ϭ $1.5 billion). If the PwC acquisition works out as planned, the value of IBM will

be increased by $1.5 billion!

Not all investment decisions are success-

ful. Just open the business section of any news- SOUND INVESTMENTS ARE THOSE
paper on any day, and you will find stories of
bad decisions. For example, Universal Picture’s WHERE THE VALUE OF THE BENEFITS BUILDING
2009 comedy Land of the Lost reportedly cost EXCEEDS THEIR COST INTUITION
over $140 million in production and advertising
expenses, but made only $69.5 million in world- Financial managers should invest in a capi-
wide box office receipts. Even with U.S. DVD
sales of approximately $18 million, the overall tal project only if the value of its future cash
cash flows from sales of the movie did not come
close to covering its up-front costs. When, as in flows exceeds the cost of the project (benefits Ͼ cost). Such invest-

ments increase the value of the firm and thus increase stockhold-

ers’ (owners’) wealth. This rule holds whether you’re making the

decision to purchase new machinery, build a new plant, or buy an

entire business.

this case, the cost exceeds the value of the future

cash flows, the project will decrease the value of

the firm by that amount.

Financing Decisions

Financing decisions concern how firms raise cash to pay for their investments, as shown

in Exhibit 1.2. Productive assets, which are long term in nature, are financed by long-term

borrowing, equity investment, or both. Financing decisions involve trade-offs between ad-

vantages and disadvantages of these financing alternatives for the firm.

A major advantage of debt financing is that debt payments are tax deductible for many cor-

porations. However, debt financing increases a firm’s risk because it creates a contractual obliga-

tion to make periodic interest payments and, at maturity, to repay the amount that is borrowed.

Contractual obligations must be paid regardless of the firm’s operating cash flow, even if the

firm suffers a financial loss. If the firm fails to make payments as promised, it defaults on its debt

obligation and could be forced into bankruptcy.

In contrast, equity has no maturity, and there FINANCING DECISIONS AFFECT THE BUILDING
are no guaranteed payments to equity investors. VALUE OF THE FIRM
In a corporation, the board of directors has the
right to decide whether dividends should be paid How a firm is financed with debt and equity INTUITION
to stockholders. This means that if a dividend pay- affects the value of the firm. The reason is that
ment is reduced or omitted altogether, the firm
the mix between debt and equity affects the
taxes the firm pays and the probability that the firm will go bank-

will not be in default. Unlike interest payments, rupt. The financial manager’s goal is to determine the combination

however, dividend payments to stockholders are of debt and equity that minimizes the cost of financing the firm.

6 CHAPTER 1 I The Financial Manager and the Firm

apital structure The mix of debt and equity on the balance sheet is known as a firm’s capital structure.
he mix of debt and equity The term capital structure is used because long-term funds are considered capital, and these
hat is used to finance a firm funds are raised in capital markets—financial markets where equity and debt instruments
with maturities greater than one year are traded.
apital markets
financial markets where equity Working Capital Management Decisions
and debt instruments with
maturities greater than one Management must also decide how to manage the firm’s current assets, such as cash, inven-
ear are traded tory, and accounts receivable, and its current liabilities, such as trade credit and accounts
payable. The dollar difference between a firm’s total current assets and its total current liabili-
net working capital ties is called its net working capital, as shown in Exhibit 1.2. As mentioned earlier, working
he dollar difference between capital management is the day-to-day management of the firm’s short-term assets and liabilities.
urrent assets and current The goals of managing working capital are to ensure that the firm has enough money to pay
abilities its bills and invest any spare cash to earn interest.

The mismanagement of working capital can cause a firm to default on its debt and go
into bankruptcy, even though, over the long term, the firm may be profitable. For example, a
firm that makes sales to customers on credit but is not diligent about collecting the accounts
receivable can quickly find itself without enough cash to pay its bills. If this condition becomes
chronic, trade creditors can force the firm into bankruptcy if the firm cannot obtain alternative
financing.

A firm’s profitability can also be affected by its inventory level. If the firm has more inven-
tory than it needs to meet customer demands, it has too much money tied up in nonearning
assets. Conversely, if the firm holds too little inventory, it can lose sales because it does not
have products to sell when customers want them. Management must therefore determine the
optimal inventory level.

> BEFORE YOU GO ON

1 . What are the three most basic types of financial decisions managers must
make?

2 . Explain why you would make an investment if the value of the expected cash
flows exceeds the cost of the project.

3 . Why are capital budgeting decisions among the most important decisions in
the life of a firm?

1.2 FORMS OF BUSINESS ORGANIZATION

LEARNING OBJECTIVE In this section we look at the way firms organize to conduct their business activities. The own-
ers of a business usually choose the organizational form that will help management maximize
ole proprietorship the value of the firm. Important considerations are the size of the business, the manner in
a business owned by a single which income from the business is taxed, the legal liability of the owners, and the ability to
ndividual raise cash to finance the business.

Most start-ups and small businesses operate as either sole proprietorships or partnerships
because of their small operating scale and capital requirements. Large businesses in the United
States, such as Procter and Gamble, are most often organized as corporations. As a firm grows
larger, the benefits to organizing as a corporation become greater and are more likely to out-
weigh any disadvantages.

Sole Proprietorships

A sole proprietorship is a business owned by one person. About 75 percent of all businesses in
the United States are sole proprietorships, typically consisting of the proprietor and a handful
of employees. A sole proprietorship offers several advantages. It is the simplest type of busi-

1.2 Forms of Business Organization 7

the business and do not have to share decision-making authority. Finally, profits from a sole
proprietorship are subjected to lower income taxes than are those from the most common type
of corporation.

On the downside, a sole proprietor is responsible for paying all the firm’s bills and has un-
limited liability for all business debts and other obligations of the firm. This means that credi-
tors can look beyond the assets of the business to the proprietor’s personal wealth for payment.
Another disadvantage is that the amount of equity capital that can be invested in the business is
limited to the owner’s personal wealth, which may restrict the possibilities for growth. Finally,
it is difficult to transfer ownership of a sole proprietorship because there is no stock or other
such interest to sell. The owner must sell the company’s assets, which can reduce the price that
the owner receives for the business.

Partnerships partnership
two or more owners who have
A partnership consists of two or more owners who have joined together legally to man- joined together legally to
age a business. About 10 percent of all businesses in the United States are organized in this manage a business and share
manner. To form a partnership, the owners enter into an agreement that details how much in its profits
capital each partner will contribute to the partnership, what their management roles will
be, how key management decisions will be made, how the profits will be divided, and how limited liability
ownership will be transferred in case of specified events, such as the retirement or death of the legal liability of a limited
a partner. partner or stockholder in a
business, which extends only
A general partnership has the same basic advantages and disadvantages as a sole pro- to the capital contributed or
prietorship. A key disadvantage of a general partnership is that all partners have unlimited the amount invested
liability for the partnership’s debts and actions, regardless of what proportion of the business
they own or how the debt or obligations were incurred. The problem of unlimited liability corporation
can be avoided in a limited partnership, which consists of general and limited partners. Here, a legal entity formed and
one or more general partners have unlimited liability and actively manage the business, authorized under a state
while each limited partner is liable for business obligations only up to the amount of capital charter; in a legal sense, a
he or she contributed to the partnership. In other words, the limited partners have limited corporation is a “person”
liability. To qualify for limited partner status, a partner cannot be actively engaged in man- distinct from its owners
aging the business.

Corporations

Most large businesses are corporations. A corporation is a legal entity authorized under a state
charter. In a legal sense, it is a “person” distinct from its owners. Corporations can sue and
be sued, enter into contracts, issue debt, borrow money, and own assets, such as real estate.
They can also be general or limited partners in partnerships, and they can own stock in other
corporations. Because a corporation is an entity that is distinct from its owners, it can have an
indefinite life. Although only 15 percent of all businesses are incorporated, corporations hold
nearly 90 percent of all business assets, generate nearly 90 percent of revenues, and account for
about 80 percent of all business profits in the United States. The owners of a corporation are
its stockholders.

Starting a corporation is more costly than starting a sole proprietorship or partnership.
Those starting the corporation, for example, must create articles of incorporation and by-laws
that conform to the laws of the state of incorporation. These documents spell out the name
of the corporation, its business purpose, its intended life span (unless explicitly stated other-
wise, the life is indefinite), the amount of stock to be issued, and the number of directors and
their responsibilities.

A major advantage of the corporate form of business organization is that stockhold-
ers have limited liability for debts and other obligations of the corporation. The corporate
veil of limited liability exists because corporations are legal persons that borrow in their
own names, not in the names of any individual owners. A major disadvantage of the most
common corporate form of organization, compared with sole proprietorships and part-
nerships, is the way they are taxed. Because the corporation is a legal person, it must pay
taxes on the income it earns. If the corporation then pays a cash dividend, the stockhold-
ers pay taxes on that dividend as income. Thus, the owners of corporations are subject
to double taxation—first at the corporate level and then at the personal level when they

8 CHAPTER 1 I The Financial Manager and the Firm

public markets Corporations can be classified as public or private. Most large companies prefer to
markets regulated by the operate as public corporations because large amounts of capital can be raised in public
Securities and Exchange markets at a relatively low cost. Public markets, such as the New York Stock Exchange
Commission in which large (NYSE) and NASDAQ, are regulated by the federal Securities and Exchange Commission
amounts of debt and equity (SEC).2 Although firms whose securities are publicly traded are technically called public
are publicly traded corporations, they are generally referred to simply as corporations. We will follow that
convention.
privately held (closely held)
orporations In contrast, privately held, or closely held, corporations are typically owned by a small
orporations whose stock is number of investors, and their shares are not traded publicly. When a corporation is first
not traded in public markets formed, the common stock is often held by a few investors, typically the founder, a small
number of key managers, and financial backers. Over time, as the company grows in size and
Visit the Web sites of the needs larger amounts of capital, management may decide that the company should “go pub-
NYSE and NASDAQ at lic” in order to gain access to the public markets. Not all privately held corporations go public,
http://www.nyse however.
.com and http://www
.nasdaq.com to get In recent years, private businesses have increasingly been organizing as a special type
more information about of corporation, known as a Subchapter S corporation. The main advantage of an S corpora-
market activity. tion, as these are commonly called, is that stockholders receive all the benefits of a corpora-
tion while escaping the double taxation. They are taxed like the partners in a partnership.
Public corporations cannot be S corporations because S corporations cannot have more
than 100 stockholders.

imited liability Hybrid Forms of Business Organization

partnerships (LLPs) Historically, law firms, accounting firms, investment banks, and other professional groups
hybrid business organizations were organized as sole proprietorships or partnerships. For partners in these firms, all in-
hat combine some of the come was taxed as personal income, and general partners had unlimited liability for all
advantages of corporations debts and other financial obligations of the firm. It was widely believed that in professional
and partnerships; in general, partnerships, such as those of attorneys, accountants, or physicians, the partners should
ncome to the partners be liable individually and collectively for the professional conduct of each partner. This
s taxed only as personal structure gave the partners an incentive to monitor each other’s professional conduct and
ncome, but the partners have discipline poorly performing partners, resulting in a higher quality of service and greater
mited liability professional integrity. Financially, however, misconduct by one partner could result in di-
saster for the entire firm. For example, a physician found guilty of malpractice exposes every
partner in the medical practice to financial liability, even if the others never treated the
patient in question.

In the early 1980s, because of sharp increases in the number of professional malprac-
tice cases and large damages awards in the courts, professional groups began lobbying state
legislators to create a hybrid form of business organization. These organizations, known
as limited liability partnerships (LLPs), are now permitted in most states. An LLP combines
the limited liability of a corporation with the tax advantage of a partnership—there is no
double taxation. In general, income to the partners of an LLP is taxed as personal income,
the partners have limited liability for the business, and they are not personally liable for other
partners’ malpractice or professional misconduct. Other more recent organizational forms
that are essentially equivalent to LLPs include limited liability companies (LLCs) and profes-
sional corporations (PCs).

> BEFORE YOU GO ON

1 . Why are many businesses operated as sole proprietorships or partnerships?

2 . What are some advantages and disadvantages of operating as a public
corporation?

3 . Explain why professional partnerships such as physicians’ groups organize as
limited liability partnerships.

1.3 Managing the Financial Function 9

1.3 MANAGING THE FINANCIAL FUNCTION

As we discussed earlier, financial managers are concerned with a firm’s investment, financing, LEARNING OBJECTIVE 3
and working capital management decisions. The senior financial manager holds one of the top
executive positions in the firm. In a large corporation, the senior financial manager usually chief financial officer (CFO)
has the rank of vice president or senior vice president and goes by the title of chief financial the most senior financial
officer, or CFO. In smaller firms, the job tends to focus more on the accounting function, and manager in a company
the top financial officer may be called the controller or chief accountant. In this section we
focus on the financial function in a large corporation.

Organizational Structure

Exhibit 1.3 shows a typical organizational structure for a large corporation, with special at-
tention to the financial function. As shown, the top management position in the firm is the
chief executive officer (CEO), who has the final decision-making authority among all the firm’s
executives. The CEO’s most important responsibilities are to set the strategic direction of the
firm and see that the management team executes the strategic plan. The CEO reports directly
to the board of directors, which is accountable to the company’s stockholders. The board’s
responsibility is to see that the top management makes decisions that are in the best interest
of the stockholders.

The CFO reports directly to the CEO and focuses on managing all aspects of the firm’s fi-
nancial side, as well as working closely with the CEO on strategic issues. A number of positions
report directly to the CFO. In addition, the CFO often interacts with people in other functional
areas on a regular basis because all senior executives are involved in financial decisions that
affect the firm and their areas of responsibility.

Stockholders control Stockholders Audit Committee
Board controls
CEO controls Board of Directors External Auditor
CFO controls
Chief Executive Compliance and
Officer (CEO) Ethics Director

V.P. Human Resources V.P. Marketing V.P. Finance (CFO) V.P. Production

Treasurer Risk Manager Controller Internal Auditor

• Cash payments/ • Monitor firm’s risk • Financial accounting • Audit high-risk
Collections exposure in financial • Cost accounting areas
and commodities • Taxes
• Foreign exchange markets • Accounting • Prepare working
• Pension funds papers for
• Derivatives hedging • Design strategies information system external auditor
• Marketable for limiting risk • Prepare financial
• Internal consulting
securities portfolio • Manage insurance statements for cost savings
portfolio
• Internal fraud
monitoring and
investigation

EXHIBIT 1.3
Simplified Corporate Organization Chart

The firm’s top finance and accounting executive is the CFO, who reports directly to the CEO. Positions that report directly to the
CFO include the treasurer, risk manager, and controller. The internal auditor reports both to the CFO and to the audit committee
of the board of directors. The external auditor and the ethics director also are ultimately responsible to the audit committee.

10 CHAPTER 1 I The Financial Manager and the Firm

Positions Reporting to the CFO

Exhibit 1.3 also shows the positions that typically report to the CFO in a large corporation and
the activities managed in each area.

• The treasurer looks after the collection and disbursement of cash, investing excess cash so that

it earns interest, raising new capital, handling foreign exchange transactions, and overseeing
the firm’s pension fund managers. The treasurer also assists the CFO in handling important
Wall Street relationships, such as those with investment bankers and credit rating agencies.

• The risk manager monitors and manages the firm’s risk exposure in financial and com-

modity markets and the firm’s relationships with insurance providers.

• The controller is really the firm’s chief accounting officer. The controller’s staff prepares the

financial statements, maintains the firm’s financial and cost accounting systems, prepares
the taxes, and works closely with the firm’s external auditors.

• The internal auditor is responsible for identifying and assessing major risks facing the firm

and performing audits in areas where the firm might incur substantial losses. The internal
auditor reports to the board of directors as well as the CFO.

Go to the Web site External Auditors
of CFO magazine at
http://www.cfo.com Nearly every business hires a licensed certified public accounting (CPA) firm to provide an inde-
to get a better idea of pendent annual audit of the firm’s financial statements. Through this audit the CPA comes to a
the responsibilities of conclusion as to whether the firm’s financial statements present fairly, in all material respects, the
a CFO. financial position of the firm and results of its activities. In other words, whether the financial num-
bers are reasonably accurate, accounting principles have been consistently applied year to year and
do not significantly distort the firm’s performance, and the accounting principles used conform to
those generally accepted by the accounting profession. Creditors and investors require independent
audits, and the SEC requires publicly traded firms to supply audited financial statements.

The Audit Committee

The audit committee, a powerful subcommittee of the board of directors, has the responsibility
of overseeing the accounting function and the preparation of the firm’s financial statements. In
addition, the audit committee oversees or, if necessary, conducts investigations of significant
fraud, theft, or malfeasance in the firm, especially if it is suspected that senior managers in the
firm may be involved.

External auditors report directly to the audit committee to help ensure their indepen-
dence from management. On a day-to-day basis, however, they work closely with the CFO
staff. The internal auditor also reports to the audit committee to help ensure his or her inde-
pendence from management. On a day-to-day basis, however, the internal auditor, like the
external auditors, works closely with the CFO staff.

The Compliance and Ethics Director

The SEC requires that all publicly traded companies have a compliance and ethics director who
oversees three mandated programs: (1) a compliance program that ensures that the firm com-
plies with federal and state laws and regulations, (2) an ethics program that promotes ethical
conduct among executives and employees, and (3) a compliance hotline, which must include a
whistleblower program. Like the internal auditor, the compliance director reports to the audit
committee to ensure independence from management, though on a day-to-day basis the direc-
tor typically reports to the firm’s legal counsel.

> BEFORE YOU GO ON

1 . What are the major responsibilities of the CFO?

2 . Identify three financial officers who typically report to the CFO and describe
their duties.

3 . Why does the internal auditor report to both the CFO and the board of directors?

1.4 The Goal of the Firm 11

1.4 THE GOAL OF THE FIRM

For business owners, it is important to determine the appropriate goal for management deci- LEARNING OBJECTIVE 4
sions. Should the goal be to try to keep costs as low as possible? or to maximize sales or mar-
ket share? or to achieve steady growth and earnings? Let’s look at this fundamental question
more closely.

What Should Management Maximize?

Suppose you own and manage a pizza parlor. Depending on your preferences and tolerance
for risk, you can set any goal for the business that you want. For example, you might have a
fear of bankruptcy and losing money. To avoid the risk of bankruptcy, you could focus on
keeping your costs as low as possible, paying low wages, avoiding borrowing, advertising
minimally, and remaining reluctant to expand the business. In short, you will avoid any ac-
tion that increases your firm’s risk. You will sleep well at night, but you may eat poorly because
of meager profits.

Conversely, you could focus on maximizing market share and becoming the largest pizza
business in town. Your strategy might include cutting prices to increase sales, borrowing heav-
ily to open new pizza parlors, spending lavishly on advertising, and developing exotic menu
items such as pizza de foie gras. In the short run, your high-risk, high-growth strategy will have
you both eating poorly and sleeping poorly as you push the firm to the edge. In the long run,
you will either become very rich or go bankrupt! There must be a better operational goal than
either of these extremes.

Why Not Maximize Profits?

One goal for decision making that seems reasonable is profit maximization. After all, don’t

stockholders and business owners want their companies to be profitable? Although profit max-

imization seems a logical goal for a business, it has some serious drawbacks.

A problem with profit maximization is that it is hard to pin down what is meant by

“profit.” To the average businessperson, profits are just revenues minus expenses. To an ac-

countant, however, a decision that increases profits under one set of accounting rules can

reduce it under another. A second problem is that accounting profits are not necessarily the

same as cash flows. For example, many firms recognize revenues at the time a sale is made,

which is typically before the cash payment for the sale is received. Ultimately, the owners

of a business want cash because only cash can be used to make investments or to buy goods

and services.

Yet another problem with profit maximization as a goal is that it does not distinguish

between getting a dollar today and getting a dollar some time in the future. In finance, the

timing of cash flows is extremely important. For example, the longer you go without paying

your credit card balance, the more interest you must pay the bank for the use of the money. The

interest accrues because of the time value of money; the longer you have access to money, the

more you have to pay for it. The time value of money is one of the most important concepts in

finance and is the focus of Chapters 5 and 6.

Finally, profit maximization ignores the uncertainty, or risk, associated with cash flows. A

basic principle of finance is that there is a trade-off between expected return and risk. When

given a choice between two investments that have

the same expected returns but different risk, most THE TIMING OF CASH FLOWS AFFECTS BUILDING
people choose the less risky one. This makes sense THEIR VALUE
because most people do not like bearing risk and,
as a result, must be compensated for taking it. The A dollar today is worth more than a dollar in INTUITION
profit maximization goal ignores differences in
value caused by differences in risk. We return to the future because if you have a dollar today,
the important topics of risk, its measurement, and
the trade-off between risk and return in Chapter 7. you can invest it and earn interest. For busi-

nesses, cash flows can involve large sums of money, and receiving

money one day late can cost a great deal. For example, if a bank has
$100 billion of consumer loans outstanding and the average annual

What is important at this time is that you under- interest payment is 5 percent, it would cost the bank $13.7 million if

stand that investors do not like risk and must be every consumer decided to make an interest payment one day later.

12 CHAPTER 1 I The Financial Manager and the Firm

THE RISKINESS OF CASH FLOWS AFFECTS In sum, it appears that profit maximization
is not an appropriate goal for a firm because the
BUILDING THEIR VALUE concept is difficult to define and does not directly
account for the firm’s cash flows. What we need is a
INTUITION A risky dollar is worth less than a safe dollar. The goal that looks at a firm’s cash flows and considers
reason is that investors do not like risk and must both their timing and their riskiness. Fortunately,
be compensated for bearing it. For example, if we have just such a measure: the market value of
the firm’s stock.
two investments have the same return—say 5 percent—most people
will prefer the investment with the lower risk. Thus, the more risky
an investment’s cash flows, the less it is worth.

Maximize the Value of the Firm’s Stock

The underlying value of any asset is determined by the cash flows it is expected to generate in

the future. This principle holds whether we are buying a bank certificate of deposit, a corpo-

rate bond, or an office building. Furthermore, as we will discuss in Chapter 9, when security

analysts and investors on Wall Street determine the value of a firm’s stock, they consider (1)

the size of the expected cash flows, (2) the timing of the cash flows, and (3) the riskiness of the

cash flows. Notice that the mechanism for determining stock values overcomes all the cash

flow objections we raised with regard to profit maximization as a goal.

Thus, an appropriate goal for management is to maximize the current value of the firm’s

stock. Maximizing the value of the firm’s stock is an unambiguous objective that is easy to

measure. We simply look at the market value of the stock in the newspaper on a given day

to determine the value of the stockholders’ shares and whether it went up or down. Publicly

traded securities are ideally suited for this task because public markets are wholesale markets

with large numbers of buyers and sellers where securities trade near their true value.

What about firms whose equity is not publicly traded, such as private corporations and

partnerships? The total value of the stockholder or partner interests in such a business is equal

to the value of the owner’s equity. Thus, our goal can be restated for these firms as this: maximize

the current value of owner’s equity. The only other restriction is that the entities must be for-

profit businesses.

It is important to recognize that maximizing the value of stock, or owner’s equity, is not

necessarily inconsistent with maximizing the value of claims to the firm’s other stakeholders.

For example, suppose the managers of a firm decide to delay paying suppliers in an effort to

increase the cash flows to the firm’s owners. An ac-

BUILDING THE FINANCIAL MANAGER’S GOAL IS TO tion such as this is likely to be met by resistance
MAXIMIZE THE VALUE OF THE FIRM’S STOCK from suppliers who might increase the prices they
charge the firm in order to offset the cost of this
INTUITION The goal for financial managers is to make de- policy to them. In the extreme, the suppliers might
stop selling their products to the firm and both the
cisions that maximize the firm’s stock price. By firm’s owners and the suppliers can end up worse
off. Consequently, in maximizing the value of
maximizing stock price, management will help the owner’s equity, managers make decisions that
maximize stockholders’ wealth. To do this, managers must make account for the interests all stakeholders. Quite of-
ten, what is best for the firm’s owners also benefits
investment and financing decisions so that the total value of cash
inflows exceeds the total value of cash outflows by the greatest

possible amount (benefits Ͼ costs). Notice that the focus is on
maximizing the value of cash flows, not profits.

other stakeholders.

Can Management Decisions Affect Stock Prices?

An important question is whether management decisions actually affect the firm’s stock price.
Fortunately, the answer is yes. As noted earlier, a basic principle in finance is that the value of an
asset is determined by the future cash flows it is expected to generate. As shown in Exhibit 1.4,
a firm’s management makes numerous decisions that affect its cash flows. For example, manage-
ment decides what type of products or services to produce and what productive assets to purchase.
Managers also make decisions concerning the mix of debt and equity financing the firm uses, debt
collection policies, and policies for paying suppliers, to mention a few. In addition, cash flows are
affected by how efficient management is in making products, the quality of the products, man-

1.5 Agency Conflicts: Separation of Ownership and Control 13

Economic shocks The Economy Current EXHIBIT 1.4
1. Wars 1. Level of economic stock Major Factors Affecting
2. Natural disasters activity market Stock Prices
2. Level of interest rates conditions
Business environment 3. Consumer sentiment The firm’s stock price is
1. Antitrust laws affected by a number of
2. Environmental regulations Expected cash flows Stock factors, and management
3. Procedural and safety 1. Magnitude price can control only some of
regulations 2. Timing them. Managers exercise
4. Taxes 3. Risk little control over external
conditions (blue boxes), such
The Firm as the general economy,
1. Line of business although they can closely
2. Financial management observe these conditions
decisions and make appropriate
a. Capital budgeting changes in strategy. Also,
b. Financing the firm managers make many other
c. Working capital decisions that directly affect
management the firm’s expected cash flows
3. Product quality and cost (green boxes)—and hence the
4. Marketing and sales price of the firm’s stock.
5. Reseach and development

new products. Some of these decisions affect cash flows over the long term, such as the decision to
build a new plant, and other decisions have a short-term impact on cash flows, such as launching
an advertising campaign.

The firm’s managers also must deal with a number of external factors over which they have
little or no control, such as economic conditions (recession or expansion), war or peace, and
new government regulations. External factors are constantly changing, and management must
weigh the impact of these changes and adjust its strategy and decisions accordingly.

The important point here is that, over time, management makes a series of decisions when
executing the firm’s strategy that affect the firm’s cash flows and, hence, the price of the firm’s
stock. Firms that have a better business strategy, are more nimble, make better business deci-
sions, and can execute their plans well will have a higher stock price than similar firms that just
can’t get it right.

> BEFORE YOU GO ON

1 . Why is profit maximization an unsatisfactory goal for managing a firm?

2 . Explain why maximizing the current market price of a firm’s stock is an appro-
priate goal for the firm’s management.

3 . What is the fundamental determinant of an asset’s value?

1.5 AGENCY CONFLICTS: SEPARATION OF OWNERSHIP AND CONTROL

We turn next to an important issue facing stockholders of large corporations: the separation LEARNING OBJECTIVE 5
of ownership and control of the firm. In a large corporation, ownership is often spread over a
large number of stockholders who may effectively have little control over management. Man-
agement may therefore make decisions that benefit their own interests rather than those of the
stockholders. In contrast, in smaller firms owners and managers are usually one and the same,
and there is no conflict of interest between them. As you will see, this self-interested behavior

14 CHAPTER 1 I The Financial Manager and the Firm

agency conflicts Ownership and Control
onflicts of interest between
a principal and an agent To illustrate, let’s continue with our pizza parlor example. As the owner of a pizza parlor, you
have decided your goal is to maximize the value of the business, and thereby your ownership
interest. There is no conflict of interest in your dual roles as owner and manager because your
personal and economic self-interest is tied to the success of the pizza parlor. The restaurant has
succeeded because you have worked hard and have focused on customer satisfaction.

Now suppose you decide to hire a college student to manage the restaurant. Will the new
manager always act in your interest? Or could the new manager be tempted to give free pizza
to friends now and then or, after an exhausting day, leave early rather than spend time clean-
ing and preparing for the next day? From this example, you can see that once ownership and
management are separated, managers may be tempted to pursue goals that are in their own
self-interest rather than the interests of the owners.

Agency Relationships

The relationship we have just described between the pizza parlor owner and the student man-
ager is an example of an agency relationship. An agency relationship arises whenever one party,
called the principal, hires another party, called the agent, to perform some service on behalf of
the principal. The relationship between stockholders and management is an agency relation-
ship. Legally, managers (who are the agents) have a fiduciary duty to the stockholders (the prin-
cipals), which means managers are obligated to put the interests of the stockholders above their
own. However, in these and all other agency relationships, the potential exists for a conflict of
interest between the principal and the agent. These conflicts are called agency conflicts.

agency costs Do Managers Really Want to Maximize Stock Price?
he costs arising from conflicts
of interest between a principal It is not difficult to see how conflicts of interest between managers and stockholders can arise in
and an agent; for example, the corporate setting. In most large corporations, especially those that are publicly traded, there is
between a firm’s owners and a significant degree of separation between ownership and management. The largest corporations
ts management can have more than one million stockholders. As a practical matter, it is not possible for all of the
stockholders to be active in the management of the firm or to individually bear the high cost of
monitoring management. The bottom line is that stockholders own the corporation, but managers
control the money and have the opportunity to use it for their own benefit.

How might management be tempted to indulge itself and pursue its self-interest? We need
not look far for an answer to this question. Corporate excesses are common. High on the list
are palatial office buildings, corporate hunting and fishing lodges in exotic places, expensive
corporate jets, extravagant expense-account dinners kicked off with bottles of Dom Perignon
and washed down with 1953 Margaux—and, of course, a king’s compensation package.3 Besides
economic nest feathering, corporate managers may focus on maximizing market share and
their industry prestige, job security, and so forth.

Needless to say, these types of activities and spending conflict with the goal of maximizing
a firm’s stock price. The costs of these activities are called agency costs. Agency costs are the
costs incurred because of conflicts of interest between a principal and an agent. Examples are
the cost of the lavish dinner mentioned earlier and the cost of a corporate jet for executives.
However, not all agency costs are frivolous. The cost of hiring an external auditor to certify
financial statements is also an agency cost.

Aligning the Interests of Management and Stockholders

If the linkage between stockholder and management goals is weak, a number of mechanisms can
help to better align the behavior of managers with the goals of stockholders. These include (1)
board of directors, (2) management compensation, (3) managerial labor market, (4) other manag-
ers, (5) large stockholders, (6) the takeover market, and (7) the legal and regulatory environment.

3A favorite premeal “quaffing” champagne of young investment bankers on Wall Street is Dom Perignon, known as the
“Domer,” which is priced in the range of $250 a bottle. Senior partners who are more genteel are reported to favor a
1953 Margaux, a French Bordeaux wine from Château Margaux; 1953 is considered a stellar vintage year, and Margaux

1.5 Agency Conflicts: Separation of Ownership and Control 15

Board of Directors

A corporation’s board of directors has a legal responsibility to represent stockholders’ inter-
ests. The board’s duties include hiring and firing the CEO, setting his or her compensation,
and monitoring his or her performance. The board also approves major decisions concerning
the firm, such as the firm’s annual capital budget or the acquisition of another business. These
responsibilities make the board a key mechanism for ensuring that managers’ decisions are
aligned with those of stockholders.

How well boards actually perform in this role has been questioned in recent years. As an
example, critics point out that some boards are unwilling to make hard decisions such as firing
the CEO when a firm performs poorly. Other people believe that a lack of independence from
management is a reason that boards are not as effective as they might be. For example, the CEO
typically chairs the board of directors. This dual position can give the CEO undue influence
over the board, as the chairperson sets the agenda for and chairs board meetings, appoints
committees, and controls the flow of information to the board.

Management Compensation

The most effective means of aligning the interests of managers with those of stockholders
is a well-designed compensation (pay) package that rewards managers when they do what
stockholders want them to do and penalizes them when they do not. This type of plan is
effective because a manager will quickly internalize the benefits and costs of making good
and bad decisions and, thus, will be more likely to make the decisions that stockholders want.
Therefore, there is no need for some outside monitor, such as the board of directors, to try to
figure out whether the managers are making the right decisions. The information that outside
monitors have is not as good as the managers’ information, so these outside monitors are
always at a disadvantage in trying to determine whether a manager is acting in the interest of
stockholders.

Most corporations have management compensation plans that tie compensation to the
performance of the firm. The idea behind these plans is that if compensation is sensitive to
the performance of the firm, managers will have greater incentives to make decisions that
increase the stockholders’ wealth. Although these incentive plans vary widely, they usu-
ally include (1) a base salary, (2) a bonus based on accounting performance, and (3) some
compensation that is tied to the firm’s stock price.4 The base salary assures the executive of
some minimum compensation as long as he or she remains with the firm, and the bonus
and stock price–based compensation are designed to align the manager’s incentives with
those of the stockholders. The trick in designing such a program is to choose the right mix
of these three components so that the manager has the right incentives and the overall
package is sufficiently appealing to attract and retain high-quality managers at the lowest
possible cost.

Managerial Labor Market

The managerial labor market also provides managers with incentives to act in the interests of
stockholders. Firms that have a history of poor performance or a reputation for “shady opera-
tions” or unethical behavior have difficulty hiring top managerial talent. Individuals who are
top performers have better alternatives than to work for such firms. Therefore, to the extent
that managers want to attract high-quality people, the labor market provides incentives to run
a good company.

Furthermore, studies show that executives who “manage” firms into bankruptcy or are
convicted of white-collar crimes can rarely secure equivalent positions after being fired for
poor performance or convicted for criminal behavior. Thus, the penalty for extremely poor
performance or a criminal conviction is a significant reduction in the manager’s lifetime earn-
ings potential. Managers know this, and the fear of such consequences helps keep them work-
ing hard and honestly.5

4This component, which may include stock options, will increase and decrease with the stock price.
5Nonquantifiable costs of convictions for crimes are the perpetrators’ personal embarrassment and the embarrassment
of their families and the effect it may have on their lives. On average, the overall cost of such convictions is higher than

16 CHAPTER 1 I The Financial Manager and the Firm

Other Managers

Competition among managers within firms also helps provide incentives for management to
act in the interests of stockholders. Managers compete to attain the CEO position and in do-
ing so try to attract the board of directors’ attention by acting in the stockholders’ interests.
Furthermore, even when a manager becomes CEO, he or she is always looking over his or her
shoulder because other managers covet that job.

Large Stockholders

All stockholders have an interest in providing managers with incentives to maximize stock-
holder value. However, as we noted earlier, most stockholders own too few shares to make
it worthwhile for them to actively monitor managers. Only large stockholders, those with
a significant investment in the firm, have enough money at stake and enough power to
make it worthwhile for them to actively monitor managers and to try to influence their
decisions.

The Takeover Market

The market for takeovers provides incentives for managers to act in the interests of stockhold-
ers. When a firm performs poorly because management is doing a poor job, an opportunity
arises for astute investors, so-called corporate raiders, to make money by buying the company
at a price that reflects its poor performance and replacing the current managers with a top-
flight management team. If the investors have evaluated the situation correctly, the firm will
soon be transformed into a strong performer, its stock price will increase, and investors can sell
their stock for a significant profit. The possibility that a firm might be discovered by corporate
raiders provides incentives for management to perform well.

The Legal and Regulatory Environment

Finally, the laws and regulations that firms must adhere to limit the ability of managers to make
decisions that harm the interests of stockholders. An example is federal and state statutes that
make it illegal for managers to steal corporate assets. Similarly, regulatory reforms such as the
Sarbanes-Oxley Act, discussed next, limit the ability of managers to mislead stockholders.

To find out more about Sarbanes-Oxley and Other Regulatory Reforms
the Sarbanes-Oxley Act,
visit http://www.soxlaw Managers of public firms in the United States have long been required to make audited
.com. financial statements available to investors which show how their firms have been performing,
what their assets are, and how those assets have been financed. Prior to 1933, these disclo-
sure requirements were specified by the individual states in which firms were incorporated.
Since the passage of the Securities Act of 1933, also known as the Truth in Securities Act,
these requirements have been standardized throughout the country. They have evolved to the
point at which financial reports must adhere to the Generally Accepted Accounting Principles
(GAAP), which are discussed in Chapter 3.

With the longstanding disclosure requirements for public firms, many investors during
the latter part of the 1900s were comfortable with the quality of corporate financial statements.
However, a series of accounting scandals and ethical lapses by corporate officers shocked the
nation in the early years of the twenty-first century. A case in point was WorldCom’s bank-
ruptcy filing in 2002 and the admission that its officers had “cooked the books” by misstating
$7.2 billion of expenses, which allowed WorldCom to report profits when the firm had actually
lost money. The accounting fraud at WorldCom followed similar scandals at Enron, Global
Crossing, Tyco, and elsewhere. These scandals—and the resulting losses to stockholders—led
to a set of far-reaching regulatory reforms passed by Congress in 2002.6 The most significant
reform measure to date is the Sarbanes-Oxley Act of 2002, which focuses on (1) reducing
agency costs in corporations, (2) restoring ethical conduct within the business sector, and (3)
improving the integrity of accounting reporting system within firms.

6The major laws passed by Congress in this area in 2002 were the Public Accounting Reform and Investor Protection