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Seventh Edition, by Arthur J. Keown, John D. Martin, and J. IMlliam Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
fi
EAR
EBIT EBITDA
E01
beta effective annual rate earnings before interest and taxes earnings before interest, taxes, depreciation, and amortization Economic Value Added the annual free cash flow in time period t the future value of $1 at the end of year i the initial outlay internal rate of return weighted average cost of capital cost of common equity cost of new common equity cost of debt financing the modified internal rate of return
FCFt
FVi 10
IRR
Kwacc
the number of years until payment will be received or during which compounding occurs net present value operating return on assets current selling price of a security profitability index the annuity payment deposited or received each period over the life of the annuity. the present value of a future sum of money required rate of return of an investor. risk free rate of interest. expected rate of return on the market portfolio of all risky investments.
NPV
OROA P
PI PMT
PV
r
ROA
Foundations of Finance; The Logic and Practice of Financial Management, Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Foundations of Finance
The Logic and Practice of Financial Management
Seventh Edition
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Mishkin/Eakins Financial iHarkets and InItitutions Moffert Cases inlmernational Finance Finance
MoffettiStonehilllEiteman Fundameutals ofiHnltinational Nofsinger PJ:yciJolop)'of1nve.fting Oudenl)en/O'Connor Advanced Corporate Finance Pennacchi Tbeory of Asset P,'icing Rejda Principles of Risk NIanagement Schoenebeek Intelplwing and Analyzing
Bierman/Smidt Tbe Capital Budgeting Decision: Economic Analysis of Investmellt P,"ojeetr Bodie/,"Ierton/Cleeton Financial EC01L07Ilics Brooks Fin/mcilll iHllnllgement: Can Conapts* Financial
Haugen Tbe Ncw Finallce: OVC17'f(rction, Complexity, and Uniq1lC1lCss Holden Ewel Modeling and Estimation Holden Excel il10deling IInd Estimation of Corporate Finance Holden Excel iHodeling and Estimation of Iuvestmentr in COlporate Finllnce in tbe Fundamentri/s , in tbe Fundamentals
CliekiCoval Tbe TbeOl)' IInd Pmctice of hztemational IVImwgement CopelandIWeston/Shastri Finllneial Tbeory and Corpomte Polie)' CoxIRnbinstein Options iVlm"kets
and Ill.f1I.mnce
Fi'lfmcial Statements
ScottiMartin/PettylKeown/Thateher CaIes in Finance Seiler Perfimning Cookbook Financial Studies: A iYIetbodologiwl ' Analysis
Dietrich Financilll Services and Finaneillllnstitutions: Value Creation in Tbe01] IInd P.ractiee Dorman Introduction to Risk iHIl1Ulgement and Insnnmce
Holden Exeell'vIodeling and Estimation in Investments Hughes/MacDonald Inte1'1Ultional Banking: Text and Cases Hull Fundfl1/lC1ltals ofFut/wes Hull Optionr, Futnnr, and Options l'v1arkets
Shapiro Capital Budgeting and Investment Sharpe/ AIexanderlBailey InveIt/nC11ts SolnikiMeLeavey Global Invest7lleuts SU-etcheriMichael CaIes in FinanciallVIanagement
Dufey/Giddy Cllses in Inte1'1wtionrtl Finllnce Eakins Finance in .learn Eiteman/StonehilVMoffett lVIultinationll1 Business Finance Emery/Finnerty/Stowe COlporllte Finllncilll NIrmagement Fabozzi Bond !vll1rkets: L1.nlllysisIInd Strategies Fabozzi/Modigliani CapitaI111m'kets: Institutions and Inrtrument,Fa bozzi/Modigliani/J on es/F erri Foundrrtions ofFinancill1 1l1m"kets and Imtitutions Finkler Financial iHanagement fm' Public, Hellltb, IInd Not-for-Profit Organizlltions Francis/Ibbotson Investments: A Global Penpective Fraser/Onniston Understanding Financial Statements Geisst Investment Banking in tbe Financial Systcm Giunan P.rinciples of,Hrmllgp-illl Finance *
Hull Risk 111anagement and Financial Institmions Keown Pe1:fOnalFinance: Tuming iHoney iuto vVealtb * Keown/Martin/Petty/Seott Financial.Management: P,-inciples and Applimtions Keowll/MartinIPetty , Fowldations ofFinflllcr: Tbe Logic and Pmctice of Financial lHmlagemem* KimINofsinger Cmpomte Gove1'1ulIlce LevylPost Investments Madura Penona! Finance * iViarthinsen Risk TakC1"s:Ufes and Abuses o{Financial Derivatives May/May/Andrew Effective r-Vriting: A Handbook f01"Finance People McDonald DerivmiveI il,lfn-kets McDonald FundamentalI of Derivatives iHarkets
Titman/Martin Valuation: Tbe /11'1:and Science of COlpomte InvestlJlent Decisions Trivoli Penonal Portfolio N[al1age7lleut: Fundamentals and Stmtegies Van Home Financial iYIanage7llent and Po/il)' Van Home Finrmcifr/ lHarket Rates and Flows Van HomelVVaehowiez Fundfl1nentftls of Financial Nlfl1lagement Vaughn Financial Plfl1wingjor tbe Entl"ep,-eneur
Welch COlpomte Finance: An Introduction * Weston/MiteheVMulherin Jilkeovers, Re.\'l:rtlctu6ng, and Cwp'omte Gove172{(JlCe \VingerlF rasea Penonal Finance
(j.,
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Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Foundations of Finance
The Logic and Practice of Financial Management
Seventh Edition
Arthur
Virginia
J.
I(eown
John D. Martin
Baylor University Professor of Finance Carr P.Collins Chair in Finance
J. William
Petty
Prentice Hall
Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo
Foundations of Finance: The Logic and Practice of Financial Management, Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc. Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty.
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Keown, Arth "r .J . Foundations of finance: the logic and practice of fin,lllcial management I Arthur]. Keown, John D. Martin,]. vVilliam Petty.-7th cd. p. cm. Includes bibliographical references and index. ISBN-13: 978-0-13-611365-2 ISBN-IO: 0-13-611365-6 I. Corporations-Finance. I.i\1artin, John D. II. Petty,]. vVilliam. III. Title HG4026.F672011
Copyright 2011, 2008, 2006, 2003, 2001 by Pearson Education, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. For information on obtaining permission for use of material in this work, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 501 Boylston Street, Suite 900, Boston, i\JA 02116, fax your request to 617-671-3447, or e-mail at http://www.pearsonecl.col11/1egal!permissions.hml. 2 3 4 5 6 7 8 9 IO-CRK-14 13 12 11 10
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Seventh Edition, by Arthur J. Keown, John D. Martin, and J. IIV1l1iam Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
To the Martin women-wife Sally and daughter-in-law Mel, the Martin men-sons Dave andJess, and Martin boys-grandsons Luke and Burke.
John D. Martin
To my grandchildren, Mackenzie Kate, Ashley Kate, Cameron Petty, John Carter, and Erin Marie, who bless me every day and make my life so much fun.
J. William Petty
Foundations of Finance; The Logic and Practice of Financial Management, Seventh Edition, by Arthur J Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D Martin, and J. IMlliam Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
John D. Martin
is Professor of Finance and the holder of the Carr P. Collins Chair of Finance at Baylor University. Dr. Martin came to Baylor University in 1998 from the University of Texas at Austin where he taught for nineteen years and was the 1\1argaret and Eugene 1\1cDennott Centennial Professor of Finance. He teaches corporate finance and his research interests are in corporate governance, the evaluation of firm performance, and the design of incentive compensation plans. Dr. Martin has published widely in academic journals including the Journal of Financial Economics, The Journal ofFinrmce,
Journal of i110netary EconomirI, Journal of Financial and Quantitative Analysi.r, Journal of Corporate Finance, Financial iWanagement, and iWanagement Science. His work has also appeared in a number of professional publications including Directors and Boards, the Financial Analy.rts' .Journal, the .Journal of Portfolio lV!anagement, and the .Journal of Applied Corporate Finance. In addition to this book Dr. Martin is co-author of nine books including Financial il1anagement (9th ed., Prentice Hall), The Tbeory of Finance (Dryden Press), Financial Analysis (2nd ed., McGraw Hill), and Value Based Management (Harvard
Business School Press), and he is currently writing a book on interest rate modeling. He serves on the editorial boards of eight journals and has delivered executive education programs for a number of firms including Shell Chemical, Shell E&P, 1exas Instruments, and The Associates.
J. William Petty, Ph 0,
University onexas at Austin, is Professor of Finance and W. \tv. Caruth Chair of Entrepreneurship. Dr. Petty teaches entrepreneurial finance, both at the undergraduate and graduate levels. He is a University Master 'Teacher. Tn 2008, the Acton Foundation for Entrepreneurship Excellence selected him as the National Entrepreneurship 'Teacher ofthe Year. His research interests include the financing of entrepreneurial firms and shareholder value-based management. He has served as the co-editor for the .Journal of Financial Re.rearcb and the editor of the Journal of E'lt1'epreneurial Finance. He has published articles in various academic and professional
vii
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition. by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Contents
Preface xxm
IZ!D
6 7 8
10
11
12
Form and Taxes:The Double Taxation on Dividends and Limited Liability Companies (LLC) 14 14 Form Should Be Chosen?
14
Which Organizational
18
19
The Money Market Versus the Capital Market Spot Markets Versus Futures Markets Organized
The Investment-Banking
Functions Distribution 2S
Function
25
Industry 26
Investment-Banking
29
Cautionary Problems
Regulation
Tale Forgetting 30
31
xi
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
journals including Journal of Financial and Quantitative Analysis, Financial lV!anagement, Journal of Portfolio lV!anagement, Journal of Applied Corporate Finance, and Accounting Review. Dr. Petty is co-author of a leading textbook in small business and entrepreneurship, Small Business A1anagement: Launching and Growing Ent7-epreneurial Ventures. He also co-authored Value-Based iVlanagement: Corporate America's Response to the Shareholder Revolmion, 2010. Finally, he serves on the Board of Directors of a publicly-traded oil and gas firm.
Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Brief Contents
IIZ!i1D
1 2 3 4
&D
5 6 7 8 9
118
156
234
Ii'!iJII
10
264
302
11
336
336 372
436
466
503 512
ix
Foundations of Finance: The Logic and Practice of Financial Management, Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc. Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty.
Contents
Capital Rationing
Capital Rationing
282
282 283 and Project Selection
Ranking Mutually
The Size-Disparity The Time-Disparity The Unequal-Lives
Exclusive Projects
Problem Problem Problem 284 28S 286
284
Summary 291. Key Terms 293 Re"iew Questions 29.3 Self-Test Problems Stlldlj Problems 294 Mini Case 299 SeiFTeslSolnliol1 .301
11
302
302
Profits 303
Use Free Cash Flows Rather than Accounting Beware of Cash Flows Diverted Work in Working-Capital Incremental RememberThat
Requirements
for Opportunity
Decide If Overhead
306 306
What Goes Into the Terminal Cash Flow the Free Cash Flows A Comprehensive Example: Calculating
Can You Do It? Calculating Did You Get It? Calculating Can You Do It? Calculating
Operating Operating
312 313
316
in Capital Budgeting:The
317
Decision
318
318 Systematic Risk Purposes with a Dose of Reality-Is
What Measure of Risk Is Relevant in Capital Budgeting? Risk for Capital-Budgeting 320 All There Is?
Incorporating
Risk-Adjusted Measuring
320
a Project's Systematic
Using Accounting
323
324
325
Foundations of Finance: The Logic and Practice of Financial Managemenl, Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Contents
Can You Do It? Calculating Can You Do It? Calculating Did You Get It? Calculating Did You Get It? Calculating
Issues in Implementing Issues in Implementing
240 240
the Cost of Preferred Stock Financing the Cost of Debt Financing 241
241
Can You Do It? Calculating Growth Model 243 Can You Do It? Calculating
243
Finance at Work IPOs: Should a Firm Go Public? The Weighted Average Cost of Capital 245
245
Cautionary Calculating
Tale Forgetting
248
248
Finance at Work The Pillsbury Company Adopts EVA with a Grassroots Education Program 249 the Weighted Average Cost of Capital 250 251 252
Using a Firm's Cost of Capital to Evaluate New Capital Investments Finance at Work Weighted Average Costs of Capital Estimates: 1993-2005 Finance and the Multinational Countries? 253 253 254 Firm:Why
Can You Do It? Evaluating Interest Rate Parity Across Countries Did You Get It? Evaluating Interest Rate Parity Across Countries Summary 255' Study Problems Key Terms 256' Review Questions 257' 258' MiJli Case 260' Self-Test Solutions
257
mIll
10
264
Cautionary Tale Forgetting Principle 3: Risk Requires a Reward and Principle 4: Market Prices Are Generally Right 266 Capital-Budgeting
The Payback Period The Net Present Value Using Spreadsheets
Decision Criteria
267 268
267
271
the NPVof
Ratio)
a Project
272
271
Index (Benefit-Cost
273
276
277
Relationship:The
277
278
Using Spreadsheets
Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Contents
in a Nutshell
35 35
Estimating Specific Interest RatesUsing Risk Premiums: An Example Realand Nominal Ratesof Interest 35 Can You Do It? Did You Get It?
35 36
37 37 38
Inflation and RealRatesof Return:The Financial Analyst's Approach Can You Do It? Solving for the Real Rate of Interest Did You Get It? Solving for the Real Rate of Interest
The Term Structure of Interest Rates 39 Observing the Historical Term Structures of Interest Rates 39 Can You Do It? Solving for the Nominal Rate of Interest Did You Get It? Solving for the Nominal Rate of Interest What Explains the Shape of the Term Structure? Finance and the Multinational Intercountry Risk 42 44 Revieu' Questions 44' Study Problems 45 40 39 40
Can You Do It? Preparing an Income Statement Did You Get It? Preparing an Income Statement The Balance Sheet Types of Assets 54 Finance at Work Goldman Sachs Announces Earnings 56 Types of Financing 56 Working Capital 58 Debt Ratio 59 Can You Do It? Preparing a Balance Sheet Did You Get It? Preparing a Balance Sheet Measuring Cash Flows 61 59 60 53
Can You Do It? How Much Can You Trust a Brother-In-Law? Did You Get It? How Much Can You Trust a Brother-In-Law? Can You Do It? Measuring Did You Get It? Measuring Income Taxes and Finance Computing Taxable Income Computing the TaxesOwed Can You Do It? Computing Did You Get It? Computing Cash Flows Cash Flows 69 69 70 a Corporation's a Corporation's Income Taxes Income Taxes 68 69
66 68
Summary 72' Key Tenus 72 RC'(Jiew Questions 73' Study Problems 74' Mini Case 79' Self-Test Solution
84
Question 1:How Liquid Isthe Firm-Can It PayIts Bills? 89 Cautionary Tale Forgetting Principle 3: Risk Requires a Reward 90
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown,John D. Martin, and J. William Petty. Publishedby Prentice Hall. Copyright 2011 by Pearson Education,Inc.
Contents
92
Adequate Operating Profits on the
Did You Get It? Evaluating Disney's Liquidity Finance at Work Managing by the Numbers
93 95 Return on Assets 97 96
Return on Assets 99
98
Did You Get It? Evaluating Disney's Financing Decisions Can You Do It? Evaluating Disney's Return on Equity Did You Get It? Evaluating Disney's Return on Equity
Question 5:Are the Firm's Managers Creating Shareholder
Value?
103
Disney's Price/Earnings
Disney's Price/Earnings
107
108 110
Key Terms 109 Reviel.l' Questions 109 SelF Test Problems 111 iVliuiCase :L16 SelFTest Solutions lJ6
miD
5
118
119
119 Time 123 127 128
Tale Forgetting
131
Can You Do It? Solving for the Present Value with Two Flows in Different Years Annuities
Compound
131 132
Annuities 132
Did You Get It? Solving for the Present Value with Two Flows in Different Years
Annuities Amortized
133
134 Due Loans 136 138
140
Periods 141
Can You Do It? How Much Can You Afford to Spend on a House? An Amortized Loan with Monthly Payments 142
Did You Get It? How Much Can You Afford to Spend on a House? An Amortized Loan with Monthly Payments 143
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Contents
144
The Multinational
Summary 147' Key Terms 147' Review Questions 148' Study Problems 148' Mini Case 154' Self-Test Solutions
Risk Defined and Measured Did You Get It? Computing Can You Do It? Computing
Finance at Work A Different Perspective of Risk Ethics in Financial Management Did You Get It? Computing
Rates of Return: The Investor's Experience Finance at Work Hard Lessons Risk and Diversification
Diversifying Measuring Away the Risk Market Risk 168
166
167
167
Beta
173
172
Beta
174
174
Demonstrated
175
Finance at Work Does BE;!ta Always Work? Can You Do It? Computing Did You Get It? Computing Summary 179' Study Problems
KC1)Terms 179' Review Questious 180' 181' Miui Case 184' Selj~Test Solutions
188
189
Finance at Work Alcoa: How to Raise $1.5 Billion Ahead of Weak Earnings Terminology
Par Value Coupon Maturity Indenture Bond Ratings
191
and Characteristics
192 192
of Bonds
191
Claims on Assets and Income Interest Rate 192 192 193 193 192
Call Provision
Finance at Work Clear Channel Rating Is Cut Defining Value What Determines 194 Value? 195
194
Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Contents
Valuation:The
Basic Process
196 197
an Asset's Value
Did You Get It? Computing Can You Do It? Computing Did You Get It? Computing Bond Yields 201
Yield to Maturity 201 Current Yield 202 Bond Valuation: Three Important Can You Do It? Computing Did You Get It? Computing Relationships 202 and Current Yield 203 204 208
Summary 206 .Key Terms 207 Review Questions 207 Self-Test Problems Studtf Problems 208 Mini Case 210 SelF Test Solutious 210
21 2
Finance at Work Reading a Stock Quote in the Wall Street Journal Can You Do It? Valuing Preferred Stock Did You Get It? Valuing Preferred Stock Common Stock 218 218 217 218
217
Finance at Work Does Stock by Any Other Name Smell as Sweet? Valuing Common Stock Cautionary Tale Forgetting 220 Principle 4-Market
219
222
Can You Do It? Measuring Johnson & Johnson's Growth Rate Did You Get It? Measuring Johnson & Johnson's Growth Rate Can You Do It? Calculating Common Stock Value 224 225 225 225 226 227 227
The Expected Rate of Return of Preferred Stockholders Did You Get It? Calculating Common Stock Value
The Expected Rate of Return of Common Stockholders Can You Do It? Computing Did You Get It? Computing
Summary 228 .Key Terms 229 Review Questiolls 229 Self-Test Problems Study Problems 230 Mini Case 232 Self-Test Solutions 232
230
234
and Concepts 235 235 236
Opportunity Costs,Required Ratesof Return,and the Cost of Capital Can You Do It? Determining
The Firm'sFinancial Policy and the Cost of Capital Determining the Costs of the Individual 237
Sources of Capital
237
The Cost of Preferred Stock 238 The Cost of Common Equity 239 The Dividend Growth Model 239
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Contents
Can You Do It? Calculating Can You Do It? Calculating Did You Get It? Calculating Did You Get It? Calculating
Issues in Implementing Issues in Implementing
240 240
the Cost of Preferred Stock Financing the Cost of Debt Financing 241
241
243
Finance at Work IPOs: Should a Firm Go Public? The Weighted Average Cost of Capital 245
245
Cautionary Calculating
248
248
Finance at Work The Pillsbury Company Adopts EVA with a Grassroots Education Program 249 the Weighted Average Cost of Capital 250 251 252
Capital Investments
Can You Do It? Evaluating Interest Rate Parity Across Countries Did You Get It? Evaluating Interest Rate Parity Across Countries Summary 255 Study Problems Key Terms 256 Review Questious 257 258 Mini Case 260 Selj~ Test Solutions
milD
10
264
Decision Criteria
267 268
271
the NPVof
Ratio)
a Project
272
271
Index (Benefit-Cost
273
276
277
277
278
Using Spreadsheets
279 281
Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Contents
Capital Rationing
Capital Rationing
282
282 283 and Project Selection
Ranking Mutually
The Size-Disparity The Time-Disparity The Unequal-Lives
Exclusive Projects
Problem Problem Problem 284 285 286
284
Summary 291 Key Terms 293 Review Questions 293 Study Problems 294 Milli Case 299 Selj~ Test Solutioll
11
302
302
Profits 303
Use Free Cash Flows Rather than Accounting Beware of Cash Flows Diverted Work in Working-Capital Consider Incremental RememberThat Account for Opportunity
Requirements
Decide If Overhead
306 306
Can You Do It? Calculating Operating Did You Get It? Calculating Can You Do It? Calculating Operating
312 313
316
in Capital Budgeting:The
317
Decision
318
318 Systematic Risk Purposes with a Dose of Reality-Is
What Measure of Risk Is Relevant in Capital Budgeting' Risk for Capital-Budgeting 320 All There Is?
Incorporating
Risk-Adjusted Measuring
320
a Project's Systematic
Using Accounting
323
324
325
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Contents
of Risk
Ketj Terms 327 Review Questions 328 329 Mini Case 333 Self-Test Solution
328
Determining
Business Risk Operating Risk 339
336
Break-Even
Analysis
340
340 342 342
Essential Elements of the Break-Even Model Finding the Break-Even Point The Break-Even Point in Sales Dollars
Can You Do It? Analyzing the Break-Even Sales Level Operating Leverage 343
343
Did You Get It? Analyzing the Break-Even Sales Level Can You Do It? Analyzing the Effects of Operating Did You Get It? Analyzing the Effects of Operating
Leverage Leverage
Can You Do It? Analyzing the Effects of Financial Leverage Did You Get It? Analyzing the Effects of Financial Leverage
Financial Leverage 346
Can You Do It? Analyzing the Combined Leverage 347 Did You Get It? Analyzing the Combined Leverage
Combining
Effects of Operating
and Financial
Effects of Operating
348
and Financial
348
Operating and Financial Leverage
Finance at Work When Financial Leverage Proves to Be Too Much to Handle Planning Cautionary the Financing Mix 350 Principle 3: Risk Requires a Reward
3S2 352
349
Tale Forgetting
351
A Quick Look at Capital Structure Theory The Importance Independence The Moderate of Capital Structure Position Position 352 354
The Moderate
View:The
Saucer-Shaped 356
Cost-of-Capital
Curve
355
358
Structure
362
Management
359
Management
363
Finance at Work Capital Structures Around the World Summary 366 Study Problems
Key Terms 367 Review Questions 367 368 Mini Case 369 Self-Test Solutions
13
372
374
the Company's
Stock Price?
Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Contents
The Dividend
Liquidity
Decision in Practice
380 380 380 Control 380
380
Ownership
Alternative Dividend
Dividend
Policies
Payment Procedures
383
as a Dividend 384 Decision? 384 Decision 383
or Investment
Cash
385
Stock Repurchase
Key Terms 387' Review Questions 387' 388' Milli Case 389' Seif- Tl'st So/utiolls
388
Em
14
and International
392
393
Financial Variables
394
Policy on DFN
396
396
Can You Do It? Percent of Sales Forecasting Did You Get It? Percent of Sales Forecasting limitations Constructing
400
Budget Functions
401
Key Terms 403' Review Questiolls 403' 405' Mini Case 409' Self-Test Solutions
403
Working-Capital
Managing
The Risk-Return The Advantages Trade-Off
Management
413 Return Risk 414 414
412
413
The Disadvantages
of Current Liabilities:
The Appropriate
The Hedging Permanent Temporary, The Hedging
415
416
Cautionary
Tale Forgetting
416
The Cash Conversion Cycle Can You Do It? Computing Did You Get It? Computing
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J Keown, John D. Martin, and J. IMlliam Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Contents
Estimating the Cost of Short-Term Cost-of-Credit Formula 420 Can You Do It?The Approximate Sources of Short-Term Credit
421
Unsecured Sources:Accrued Wages and Taxes 421 Did You Get It?The Approximate Cost of Short-Term Credit 421 422
Finance at Work Managing Working Capital by Trimming Can You Do It?The Cost of Short-Term Credit (Considering Effects) 423 423 Unsecured Sources:TradeCredit
Receivables Compounding
Did You Get It?The Cost of Short-Term Credit (Considering Effects) 424 Unsecured Sources:Bank Credit 424 Unsecured Sources:Commercial Paper 426 Secured Sources:Accounts-Receivable Loans 427 Secured Sources:Inventory Loans 429 Multinational Working-Capital Management 429
Compounding
Summary 430' Key Terms 430' Review Questions Study Problems 432' Self-Test Solutions 435
16
431
436
439
Procedures
440
Managing the Cash Inflow-Speeding Up Collections 440 The Lockbox Arrangement 441 Managing the Cash Outflow-Slowing Down Disbursements Evaluating the Costs of Cash Management Services 444 Can You Do It? Evaluating the Cost of Cash Management The Composition of a Marketable-Securities Portfolio
Did You Get It? Evaluating the Cost of Cash Management General Selection Criteria 445 Marketable-Security Alternatives Accounts-Receivable 448 449
Management
The Terms of Sale-A Decision Variable 450 The Type of Customer-A Decision Variable 451 The Collection Effort-A Decision Variable 452 Inventory Management 452 454 455 457
Types of Inventory 453 Inventory Management Techniques Can You Do It? Calculating Did You Get It? Calculating
Summary 458' Key Terms 459' Review Questiolls 459' Self-Test Problems Study Problems 460' Mini Case 464' Self-Test Solutions 465
460
17
Contents
Spot Exchange Rates Asked and Bid Rates Cross Rates 471
Can You Do It? Using the Spot Rate to Calculate a Foreign Currency Payment
Forward Exchange Rates 472
471
Did You Get It? Using the Spot Rate to Calculate a Foreign Currency Payment Can You Do It? Computing
Exchange Rate Risk 474
472
a Percent-Per-Annum
Premium
474
a Percent-Per-Annum
Premium
475
476
Fisher Effect
478
Multinational
Working-Capital
Strategies
Management
482 of Funds
481
482
International
482
Key Terms
487
486 Review Questions 486 Mini Case 488 Self-Test Solution 491
487
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Preface
The study of finance focuses on making decisions that enhance the value of the firm. This is done by providing customers with the best products and services in a cost-effective way. In a sense we, the authors of Foundatio77s ojFiml11ce, are trying to do the same thing. That is, we have tried to present the study of financial management in a way that makes your study as easy and productive as possible by using a step-by-step approach to walking you through each new concept or problem. We are very proud of the history of this volume as it was the first "shortened book" of financial management when it was published in its first edition. The book broke new ground by reducing the number of chapters down to the foundational materials and by trying to present the subject in understandable terms. \IVe continue our quest for readability with the Seventh Edition.
xxiii
Foundations of Finance: The Logic and Practice of Financial Management. Seventh Edition, by Arthur J. Keown. John D. Martin. and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Preface
if you
(The solu-
The text provides examples for the students to work at the conclusion of each major section of a chapter, which we call, "Can You Do It?" followed by "Did You Get It?" several pages later in the text. This tool provides an essential ingredient to the building-block approach to the material that we use.
real rate of
+ +
.,.
+
product interest
of the
~
=
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(real rate of interest)
0.04
Solving
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Concept Check
At the end of most major sections, this tool highlights the key ideas just presented and allows students to test their understanding of the material.
Concept Check
1. According 2. "Vhat 3. 'What to Principle 3, how do investors decide where to invest their money) is an efficient is the, market)
.,a,!~'aii.
Firms A and B arc idcntical in size. Both have SI,OOOin total assets, and both have an operating return on assets of 14 percent. However, they are different in one respect: Firm A uses all equity and no debt financing; Firm B tinanccs 60 percent nfits investments with debt and 40 percent with equity. (For the sake of simplicity, \VC will assume that both firms pay interest at an interest cost of 6 percent, <1I1d there are no income taxes.) The fin<lJ1Cial statements for the two companies would be as follows:
FIRM BALANCE SHEET A FIRM B
Integrated Examples
These provide students with real-wo rld examples to help them apply the concepts pre'sented ]n each chapter.
Totalassets Debt (6% interest rate) Equity Total debt and equity
INCOME STATEMENT
$1,000
$1,000
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Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Preface
a number of ethical dilemmas that you have never considered. The spread of technology into the workplace has raised a
of new ethical questions, and many old ones still linger.
variety
The following is a quiz dealing with ethical questions that will both give you some questions to think about and also allow you to compare your answers with those of other Americans surveyed. Office Technology t. Is it wrong to use company ernail for personal reasons?
Yes No
9. Due to on-the-job pressure, have you ever abused or lied about sick days? Yes No
10. Due to on-the-job pressure, have you ever taken credit for someone else's work or idea?
Yes No Sources: Ethics Officer AssociatiOn. Belmont. Mass.; EthiCillleadership GrOllI'. Wilmette, III.;surveys sampled a cross-~tion of workef'5 at lafge companies andnatiorlwide
l..f;irtcipte
the )tbal1
financial manager to the process involved in raising funds in the nation's capital markets and how interest rates in those markets are determined. Without question the United States has a highly developed, complex, and competitive system of financial markets that allows for the quick transfer of savings from people and organizations with a surplus of savings to those with a savings deficit. Such a system of highly developed financial markets allows great ideas (such as the personal computer) to be financed and increases the overall wealth of the economy. Consider your wealth, for example, compared to that of the average family in Russia. Russia lacks the complex system of financial markets to facilitate securities transactions. As a result, real capital formation there has suffered. Thus, we return now to Principle 4: Market Prices Are Generally Right. Financial managers like the U.S.system of capital markets because they trust it. This trust stems from the fact that the markets are efficient, and so prices quickly and accurately reflect all available information about the value of the underlying securities. This means that the expected risks and expected cash flows matter more to market participants than do simpler things such as accounting changes and the sequence of past price changes in a specific security. With security prices and returns (such as interest rates) competitively determined, more financial managers (rather than fewer) participate in the markets and help ensure the basic concept of efficiency.
Ethics Quiz Answers 1. 34% said personal emall on company computers is wrong 2. 49% said playing computer games at work is wrong 3. 61% said it's unethical to blame your error on technology 4. 35% said a $50 gift to the boss is unacceptable 5. 12% said a $50 gift from the boss is unacceptable 6. 70% said it's unacceptable to take the $200 football tickets 7. 35% said it's unacceptable to take the $100 food basket 8. 40% said it's unacceptable to take the $75 raffle prize 9. 11% reported they lie about sick days 10. 4% reported they take credit for the work or ideas of others
Source: The Wall Street Joumal, October 21. 1999, page Dow Jones & Compaoy. Inc.) All Rights Reserved
81
{Copyright
(:'1999,
Mini
Case
The final stage in the irm;n'icw process for an assistant financial analyst at Caledonia Products involves a rest of you!' understanding of basic tlnancial concepts. You are given the following metno~ randum and asked TO respond to the q\HO'stions. \Vhcther yOll arc offcred a position atC:llcdonia \lyill depend on the accuracy of your response. To: Applic:mts for the position of Financial Analyst From: Me \.~Morrison, CEO, Caledoni\l Products Re: A test of your understanding of basic financial concepts and of the corporate tax code Please respond to the following questions: n11at is the appropriate goal for the firm and why? b. \Vhat does the risk-return trade-ofr mean? c. \Vhy arc we interested in cash flows rather than accounting profits in determining the value of an asset? d. \Vhat is an efficiellt marker and what are rhe implications of efficient markets for us? c. \Vhat is the causc of the agency problcm and how do we tnr to solve it? f. Wllar do ethics and etbical behavior have to do with f11 g Dr;flnc (I) sole proprictorship, (2) partnership, and (3) CALCULATOR SOLUTION
ll.
Financial Calculators
The use of financial calculators has been integrated throughout this text, especially with respect to the presentation of the time value of money. vVhere appropriate, calculator solutions appear in the margin.
Function Key
[&J
om ]
IPMTI Answer 279.20
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Foundations of Finance: The Logic and Practice of Financial Management, Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Preface
Content Updates
In response to both the continued development of financial thought and reviewer comments, changes have been made in the text. Some of these changes include:
Chapter 1 An Introduction
Updated and revised to make it as intuitive as possible. The principles that form the Foundations of Finan_ce were simplified and consoLidated from 10 principles down to 5 principles. In addition, a section titled Avoiding Financial Crisis-Back to the Principles was introduced. This section examines each of the principles individually and how ignoring them helped bring on the recent financial crisis. A new section on the importance of ethics and trust in financial management was introduced. In addition, new examples were added.
Chapter 2 The Financial Markets and Interest Rates
This chapter was significantly revised to reflect the recent changes in the financial markets. The chapter was simplified to make it livelier and more relevant to students. A ne\v section titled The Financing of Business: The Movement of Funds Through the Economy was added. This section illustrates the role of finance in our economy. The discussion of investment banking was revised to reflect the dramatic impact of tlle recent financial crisis on investment banking firms. GA Cautionary Tale-Forgetting Principle 5: Conflicts of Interest Cause Agency Problems was introduced illustrating the impact of ignoring the principles of finance on the recent financial crisis. The discussion of interest rates determinants was also simplified and made more intuitive . This chapter was rewritten with an eye toward providing the student with need-toknow information that is used as building blocks to understand and introduce material in subsequent chapters.
Chapter 3 Understanding
A cautionary tale illustrating the peril of forgetting the principle that cash flows determine value. A new Finance at Work drawing from a recent Fortune magazine article that highlights how the world of finance may change as a result of tlle recent financial crisis. A presentation of Hewlett-Packard's financial statements to let a student see a realworld example. A.nimproved figure that visually presents the make-up of a balance sheet was added. A totally new presentation of cash flows was added . ., The addition of a new section explaining the relevance and computation of income taxes was added. Chapter 4
Evaluating A Firm's Financial Performance
A cautionary tale that shows the danger of forgetting the principle that risk requires reward was added. A new Ethics in Financial Management acting unethically was added. that describes frequent rationalizations for
Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Preface
A new section on the use of timeJines to visuauze cash flows was added . This chapter was revised with an eye toward making it more accessible to math-phobic students. Coverage of the time value of money tables was dropped. Alternative approaches to solving time value of money problems were provided. A Cautionary Tale-Forgetting Principle 3: Risk Requires a Reward and Principle 4: Market Prices Are Generally Right was introduced. An increased emphasis on the intuition behind the time value of money was provided stressing visuaLizing and setting up the problem. Chapter 6
The Meaning and Measurement of Risk and Return
The chapter provides an expanded presentation of holding-period returns to insure that students understand the foundation concept of returns. ~Then explaining how to compute a standard deviation of returns, we developed a stepby-step approach instead of simply presenting an equation. There is a new Ethics in Financial Management box that tells the story of Aaron Beam, fonner CFO of HealthSouth Corporation, who explains how he gradually slipped in committing fraud, and what life is like for him today. The chapter offers a new presentation of risk and diversification, using Google as an example. There is a new presentation in the chapter showing the relationship between risk and return and the length of the holding period.
Chapter 7
The Valuation and Characteristics of Bonds
This chapter has been revised to provide an updared explanation with examples of the nature and characterisrics of bonds. There are all new real-world examples of how to compute the value and expected rates of returns of a bond.
The chapter presents a cautionary tale that lets a student see some of the foolish ways investors try to outperform the market, usually with disastrous results, suggesting that Principle 4, Market Prices i\re Generally Right, is active and working. liVehave simplified the presentation of stock valuation that better fits the needs of a student in a beginning finance class.
Chapter 9
The Cost of Capital
This chapter was moved to appear before the discussion of capital budgeting . The new placement provides a logical transition from the discussion of the determinants of capital market rates of return in Chapter 8 to the application of this material to the estimation of the firm's cost of capital. The plight of Goldman Sachs when the credit markets seized up in 2008 is used to illuso"ate the volatile nature of a firm's cost of capital.
Foundations of Finance. The Logic and Practice of Financial Management. Seventh Edition. by Arthur J. Keown. John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Preface
The discussion of the calculation of a project's free cash flows was simplified and made more intuitive in nature, while additional worked out problems were added to the chapter.
Chapter 12 Determining
Additional coverage of the practical considerations underlying the determination firm's dividend policy.
Chapter 14 Short-Term Financing
of a
Revised discussion of the cash conversion cycle and its role in reducing a firm's investment in working capital.
Chapter 16 Current Asset Management
Streamlined receivable.
Chapter 17 International
of accounts
Business Finance
This chapter was revised and updated to reflect changes in exchange rates and in the global financial markets in general. The section on interest rate parity was streamlined and simplified.
Preface
Study Guide
The Study Guide to accompany Foundations of Finance: The Logic and Pmctice of Financial j'vIanagement, 7th Edition, was written by the authors with the objective of providing a student-oriented supplement to the text. Each chapter of the Study Guide cont,lins ,ll1orientation of each chapter along with a chapter outline of key topics; problems (with detailed solutions) and self-tests, which can be used to aid in the preparation of outside assignments and in studying for exams; a tutorial on capital budgeting; and a set of tables that not only gives compound sum and present value interest factors but also shows how to compute the interest using a financial calculator.
Companion Website
(www.pearsonhighered.comlkeown) The vVebsite contains vanous activities related specifically to tlle Seventh Edition of FoundatiollI of Finance: Tbe Logic and Practice ofFinrl17rial fvIrl7lagement.
Excel Spreadsheets
Created by the authors, these spreadsheets correspond with the end-of-chapter problems from the text. This student resource is available on both the companion Website and 1'\1yFinanceLab.
Foundations of Finance: The Logic and Practice of Financial Management. Seventh Edition. by Arthur J. Keown. John D. Martin. and J William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Preface
Subscriptions
Analyzing current events is an important skill for economic students to develop. To sharpen this skill and further support the book's theme of exploration and application, Prentice Hall offers you and your student's three news subscription offers:
Economist.com
Through a special arrangement with Economist.com, Prentice Hall offers your students a 12-week subscription to Economist.com for a small additional charge. Upon adoption of a special package containing the book and the subscription booklet, professors will receive a free six-month subscription. Please contact your Prentice Hall representative for further details and ordering information.
Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.
Preface
Acknowledgments
,Ne gratefully acknowledge the assistance, support, and encouragement of those individuals who have contributed to the Seventh Edition of Foundations o/Finance. Specifically, we wish to recognize the very helpful insights provided by many of our colleagues. For their careful comments and helpful reviews of the text, we are indebted to: Haseeb Ahmed, Johnson C. Smith University Joan Anderssen, Arapahoe Community CoLlege Chris Armstrong, Draughons Junior College Curtis Bacon, Southern Oregon University Deb Bauer, University of Oregon Pat Bernson, County CoLlege of Monis Ed Boyer, Temple University Joe Brocato, Tarleton State University Joseph Brum, Fayetteville Technical Community College Lawrence Byerly, Thomas More College Janice Caudill, Auburn University Andreas Christofi, Monmouth University David Daglio, Newbury College Julie Dahlquist, University of Texas at San Antonio David Darst, Central Ohio Technical College Maria de Boyrie, New Mexico State University Kate Demarest, Carroll Community College Khaled Elkhal, University of Southern Indiana Cheri Etling, University of Tampa Cheryl Fetterman, Cape Fear Community College David R. Fewings, Western vVashington University Dr. Charles Gahala, Benedictine University Harry Gallatin, Indiana State University Deborah Giarusso, University of Nortllern Iowa Gregory Goussak, University of Nevada, Las Vegas Lori Grady, Bucks County Community College Ed Graham, University of North Carolina \Vilmington Barry Greenberg, Webster University Gary Greer, University ofIlouston Downtown Bruce Hadburg, University of Tampa Thomas Hiebert, University of North Carolina, Charlotte }\1arlinJ emen, Auburn University John Kachurick, Nlisericordia University Okan Kavuncu, University of California at Santa Cruz Gary Kayakachoian, Rbode Island College Lynn Phillips Kugele, University of Mississippi Mary LaPann, Adirondack Community College Carlos Liard-Muriente, Central Connecticut State University Christopher Liberty, College of St Rose, Empire State College Edmund Mantell, Pace University Peter Marks, Rhode Island College Mario Mastrandrea, Cleveland State University Anna McAleer, Arcadia University Robert Meyer, Parkland College Ronald Moy, St. John's University Elisa Muresan, Long Island University Anthony Pondillo, Siena College Walter Purvis, Coastal Carolina Community College Emil Radosevich, Central New i'vlexico Community College Deana Ray, Forsyth Technical Community CoLlege Clarence Rose, Radford University Ahmad Salam, \Videner University Jeffrey Schultz, Christian Brothers University Ken Shakoori, California State University, Bakersfield Michael Slates, Bowling Green State University Suresh Srivastava, University of Alaska Anchorage Mauny Tamarkin, Clark University Fang \Vang, \Vest Virginia University Paul V\Tarrick,\Vestwood CoLlege Jill Wetmore, Saginaw Valley State University Kevin Yost, Auburn University Jingx-ue Yuan, Texas Tech University Mengxin Zhao, Bentley College
vVe also thank our friends at Prentice Hall. Vie offer our personal expression of appreciation to our editor-in-chief Donna Battista who provided the leadership and direction to this project. vVe would also like to tlunk Tessa O'Brien, our finance editor. Tessa has been a pleasure to work with, always full of ideas and driven to help us produce the best book possible. vVewould also like to thank Sara Holliday, our project manager, for her adminisu'ative defU1ess.\Vith Sara watching over us, there W,lS no W,lY the ball could be dropped. Our hats are off to you, Sara. We would also like to extend our thanks to Heather McNally, who served as our production supervisor; we express a very special thank you for seeing the book through a velY complex production process and keeping it all on schedule while maintaining extremely high quality. Our thanks also go to Liz Averbeck for her marketing prowess. Liz has an amazing understanding of the market, coupled with an intuitive understanding of wbat the market is looking for. In addition to being a joy to work with, she is also the hardest working person in America. Vie also thank Nicole Sackin, our media producer, who did a great job of making sure we are on the cutting edge in terms of web applications and offerings. As a final word, we express our sincere thanks to those using Foundations 0/ Finance in the classroom. \Ve thank you for making us a part of your team. Always feel free to give any of us a call or contact us through the Internet when you have questions or needs. -AJ.K./ ].D.i'\1./ ].W.P.
Foundations of Finance; The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty. Published by Prentice Hall. Copyright 2011 by Pearson Education, Inc.