Part 1 Introduction to Managerial Finance

1 An Overview of Managerial Finance 2

1-1 What Is Finance? 3

1-1a General Areas of Finance 3

1-1b The Importance of Finance in Non-Finance Areas 4

1-2 Alternative Forms of Business Organization 5

1-2a Proprietorship 6

1-2b Partnership 6

1-2c Corporation 7

1-2d Hybrid Forms of Business: LLP, LLC, and S Corporation 8

1-2e Which Form of Business Is Best? 8

1-3 What Goal(s) Should Business Pursue? 9

1-3a Managerial Actions to Maximize Shareholders Wealth 10

1-3b Should Earnings per Share Be Maximized? 10

1-3c Managers’ Roles as Agents of Stockholders 12

1-4 What Roles Do Ethics and Governance Play in Business Success? 13

1-4a Business Ethics 13

1-4b Corporate Governance 14

1-5 Forms of Business in Other Countries 15

l-5a Multinational Corporations 16

1-5b Multinational Versus Domestic Managerial Finance 17

Key Managerial Finance Concepts 19

Part 2 Essential Concepts in Managerial Finance

2 Analysis of Financial Statements 22

2-1 Financial Reports 23

2-2 Financial Statements 23

2-2a The Balance Sheet 24

2-2b The Income Statement 27

2-2c Statement of Cash Flows 29

2-2d Statement of Retained Earnings 32

2-3 Financial Statement (Ratio) Analysis 32

2-3a Liquidity Ratios 32

2-3b Asset Management Ratios 34

2-3c Debt Management Ratios 35

2-3d Profitability Ratios 37

2-3e Market Value Ratios 37

2-3f Comparative Ratios (Benchmarking) and Trend Analysis 38

2-3g Summary of Ratio Analysis: The DuPont Analysis 38

2-4 Uses and Limitations of Ratio Analysis 39

2-4a Accounting in an International Setting 40

Key Financial Statement Analysis Concepts 42

3 The Financial Environment: Markets, Institutions, and Investment Banking 50

3-1 What Are Financial Markets? 51

3-1a Importance of Financial Markets 51

3-1b Flow of Funds 51

3-1c Market Efficiency 53

3-2 Types of Financial Markets 53

3-2a Stock Markets 55

3-2b Types of General Stock Market Activities 55

3-2c Physical Stock Exchanges 55

3-2d The Over-the-Counter (OTC) Market and NASDAQ 57

3-2e Electronic Communications Networks (ECN) 57

3-2f Competition Among Stock Markets 58

3-2g Regulation of Securities Markets 59

3-3 The Investment Banking Process 59

3-3a Raising Capital: Stage I Decisions 59

3-3b Raising Capital: Stage II Decisions 60

3-3c Raising Capital: Selling Procedures 61

3-4 Financial Intermediaries and Their Roles in Financial Markets 62

3-4a Types of Financial intermediaries 63

3-5 International Financial Markets 65

3-5a Financial Organizations in Other Parts of the World 66

3-5b Recent Legislation of Financial Markets 67

Key Financial Environment Concepts 69

4 Time Value of Money 74

4-1 Cash Flow Patterns 76

4-2 Future Value (FV) 77

4-2a FV of a Lump-Sum Amount-FV_n 77

4-2b FV of an Ordinary Annuity- FVA_n 79

4-2c FV of an Annuity Due-FVA(DUE)_n 79

4-2d FV of an Uneven Cash Flow Stream-FVCF_n 80

4-3 Present Value (PV) 81

4-3a PV of a Lump-Sum Amount-PV 82

4-3b PV of an Ordinary Annuity-PVA_n 82

4-3c PV of an Annuity Due-PVA(DUE)_n 83

4-3d Perpetuities 84

4-3e PV of an Uneven Cash Flow Stream-PVCF_n 84

4-3f Comparison of FV with PV-Understanding the Numbers 85

4-4 Solving for Interest Rates (r) and Time (n) 87

4-4a Solving for r 87

4-4b Solving for n 88

4-5 Annual Percentage Rate (APR) and Effective Annual Rate (EAR) 88

4-5a Semiannual and Other Compounding Periods 88

4-5b Comparison of Different Interest Rates 89

4-6 Amortized Loans 91

Key Time Value of Money Concepts 93

Part 3 Valuation-Financial Assets

5 The Cost of Money (Interest Rates) 100

5-1 The Cost of Money 101

5-1a Realized Returns (Yields) 101

5-1b Factors That Affect the Cost of Money 101

5-1c Interest Rate Levels 102

5-2 Determinants of Market Interest Rates 104

5-2a The Nominal, or Quoted, Risk-Free Rate of Interest, T_RF 105

5-2b Inflation Premium (IP) 106

5-2c Default Risk Premium (DRP) 106

5-2d Liquidity Premium (LP) 107

5-2e Maturity Risk Premium (MRP) 107

5-3 The Term Structure of Interest Rates 108

5-3a Why Do Yield Curves Differ? 109

5-3b Does the Yield Curve Signal Future Interest Rates? 113

5-4 Other Factors That Influence Interest Rate Levels 114

5-4a Federal Reserve Policy 114

5-4b Federal Deficits 115

5-4c International Business (Foreign Trade Balance) 115

5-4d Business Activity 115

5-5 Interest Rate Levels and Stock Prices 116

5-5a The Cost of Money as a Determinant of Value 116

Key Cost of Money (interest Rate) Concepts 118

6 Bonds (Debt)-Characteristicis and Valuation 124

6-1 Characteristics and Types of Debt 125

6-1a Debt Characteristics 125

6-1b Types of Debt 125

6-1c Short-Term Debt 126

6-1d Long-Term Debt 127

6-1e Bond Contract Features 129

6-1f Foreign Debt Instruments 130

6-2 Bond Ratings 131

6-2a Bond Rating Criteria 131

6-2b Importance of Bond Ratings 132

6-2c Changes in Ratings 132

6-3 Valuation of Bonds 133

6-3a The Basic Bond Valuation Model 133

6-3b Bond Values with Semiannual Compounding 134

6-4 Finding Bond Yields (Market Rates): Yield to Maturity and Yield to Call 134

6-4a Yield to Maturity (YTM) 135

6-4b Yield to Call (YTC) 135

6-5 Interest Rates and Bond Values 136

6-5a Changes in Bond Values over Time 137

6-5b Interest Rate Risk on a Bond 138

6-5c Bond Prices in Recent Years 140

Key Bond Characteristics and Valuation Concepts 143

7 Stocks (Equity)-Characteristics and Valuation 148

7-1 Types of Equity 149

7-1a Preferred Stock 149

7-1b Common Stock 150

7-1c Equity Instruments in International Markets 153

7-2 Stock Valuation-The Dividend Discount Model (DDM) 153

7-2a Expected Dividends as the Basis for Stock Values 154

7-2b Valuing Stocks with Constant, or Normal, Growth (g) 155

7-2c Valuing Stocks with Nonconstant Growth 158

7-3 Other Stock Valuation Methods 161

7-3a Valuation Using P/E Ratios 161

7-3b Evaluating Stocks Using the Economic Value Added Approach 161

7-4 Changes in Stock Prices 162

Key Stock Valuation Concepts 165

8 Risk and Rates of Return 170

8-1 Defining and Measuring Risk 171

8-1a Probability Distributions 171

8-2 Expected Rate of Return 172

8-2a Measuring Total (Stand-Alone) Risk: The Standard Deviation (σ) 172

8-2b Coefficient of Variation (Risk/Return Ratio) 174

8-2c Risk Aversion and Required Returns 174

8-3 Portfolio Risk-Holding Combinations of Investments 176

8-3a Firm-Specific Risk Versus Market Risk 179

8-3b The Concept of Beta 180

8-3c Portfolio Beta Coefficients 182

8-4 The Relationship Between Risk and Rates of Return: The CAPM 183

8-4a The Impact of Inflation 185

8-4b Changes in Risk Aversion 185

8-4c Changes in a Stock’s Beta Coefficient 186

8-4d A Word of Caution 186

8-5 Stock Market Equilibrium 186

8-6 Different Types of Risk 187

Key Risk and Return Concepts 190

Part 4 Valuation-Real Assets (Capital Budgeting)

9 Capital Budgeting Techniques 196

9-1 Importance of Capital Budgeting 197

9-1a Generating Ideas for Capital Projects 198

9-1b Project Classifications 198

9-1c The Post-Audit 199

9-2 Evaluating Capital Budgeting Projects 199

9-2a Net Present Value (NPV) 200

9-2b Internal Rate of Return (IRR) 202

9-3 Comparison of the NPV and IRR Methods 203

9-3a NPVs and Required Rates of Return-NPV Profiles 204

9-3b Independent Projects 204

9-3c Mutually Exclusive Projects 205

9-3d Cash Flow Patterns and Multiple IRRs 206

9-4 Modified internal Rate of Return 207

9-5 Use of Capital Budgeting Techniques in Practice 208

9-5a Payback Period:Traditional (Nondiscounted) and Discounted 209

9-5b Conclusions on the Capital Budgeting Decision Methods 211

9-5c Capital Budgeting Methods Used in Practice 212

Key Capital Budgeting Concepts 214

10 Project Cash Flows and Risk 220

10-1 Cash Flow Estimation 221

10-1a Relevant Cash Flows 221

10-1b Incremental (Marginal) Cash Flows 223

10-1c Identifying Incremental Cash Flows 224

10-2 Capital Budgeting Project Evaluation 226

10-2a Expansion Projects 226

10-2b Replacement Analysis 229

10-3 Incorporating Risk in Capital Budgeting Analysis 232

10-3a Stand-Alone Risk 233

10-3b Corporate (Within-Firm) Risk 236

10-3c Beta (Market) Risk 237

10-3d Project Risk Conclusions 238

10-3e How Project Risk Is Considered in Capital Budgeting Decisions 238

10-4 Multinational Capital Budgeting 239

Key Concepts About Project Cash Flows and Risk 241

Part 5 Cost of Capital and Capital Structure Concepts

11 The Cost of Capital 252

11-1 Component Costs of Capital 253

11-1a Cost of Debt, r_dT 254

11-1b Cost of Preferred Stock, r_ps 255

11-1c Cost of Retained Earnings (Internal Equity), r_s 255

11-1d Cost of Newly Issued Common Stock (External Equity), r_e 258

11-2 Weighted Average Cost of Capital (WACC) 259

11-2a Determining WACC 259

11-2b The Marginal Cost of Capital (MCC) 260

11-2c The MCC Schedule 261

11-2d Other Breaks in the MCC Schedule 263

11-3 Combining the MCC and Investment Opportunity Schedules (IOS) 266

11-4 WACC Versus Required Rate of Return of Investors 267

Key Cost of Capital Concepts 271

12 Capital Structure 278

12-1 The Target Capital Structure 279

12-1a Business Risk 280

12-1b Financial Risk 280

12-2 Determining the Optimal Capital Structure 281

12-2a EPS Analysis of the Effects of Financial Leverage 282

12-2b EBIT/EPS Examination of Financial Leverage 285

12-2c The Effect of Capital Structure on Stock Prices and the Cost of Capital 286

12-3 Degree of Leverage 288

12-3a Degree of Operating Leverage (DOL) 288

12-3b Degree of Financial Leverage (DFL) 290

12-3c Degree of Total Leverage (DTL) 291

12-4 Liquidity and Capital Structure 292

12-5 Capital Structure Theory 293

12-5a Trade-Off Theory 293

12-5b Signaling Theory 294

12-6 Variations in Capital Structures Among Firms 295

12-6a Capital Structures Around the World 296

Key Capital Structure Concepts 298

13 Distribution of Retained Earnings: Dividends and Stock Repurchases 306

13-1 Dividend Policy and Stock Value 307

13-1a Information Content, or Signaling 308

13-1b Clientele Effect 308

13-1c Free Cash Flow Hypothesis 309

13-2 Dividend Payments in Practice 309

13-2a Residual Dividend Policy 309

13-2b Stable, Predictable Dividends 311

13-2c Constant Payout Ratio 312

13-2d Low Regular Dividend Plus Extras 312

13-2e Application of the Different Types of Dividend Payments: An Illustration 313

13-2f Payment Procedures 313

13-2g Dividend Reinvestment Plans (DRIPs) 315

13-3 Factors Influencing Dividend Policy 315

13-4 Stock Dividends and Stock Splits 316

13-4a Stock Splits 316

13-4b Stock Dividends 317

13-4c Price Effects of Stock Splits and Stock Dividends 317

13-4d Balance Sheet Effects of Stock Splits and Stock Dividends 317

13-5 Stock Repurchases 319

13-5a Advantages and Disadvantages of Stock Repurchases 319

13-6 Dividend Policies Around the World 320

Key Distribution of Retained Earnings Concepts 322

Part 6 Working Capital Management

14 Managing Short-Term Financing (Liabilities) 328

14-1 Working Capital 329

14-2 The Cash Conversion Cycle 330

14-3 Current Asset (Working Capital) Financing Policies 333

14-4 Sources of Short-Term Financing 334

14-4a Accruals 335

14-4b Accounts Payable (Trade Credit) 335

14-4c Short-Term Bank Loans 335

14-4d Commercial Paper 336

14-4e Secured Loans 336

14-5 Computing the Cost of Short-Term Credit 337

14-5a Computing the Cost of Trade Credit (Accounts Payable) 338

14-5b Computing the Cost of Bank Loans 338

14-5c Computing the Cost of Commercial Paper 340

14-5d Borrowed (Principal) Amount Versus Required (Needed) Amount 340

14-6 Multinational Working Capital Management 343

Key Concepts for Managing Short-Term Financing 344

15 Managing Short-Term Assets 350

15-1 Alternative Current Asset Investment Policies 351

15-2 Cash Management 352

15-2a The Cash Budget 352

15-2b Cash Management Techniques 356

15-2c Acceleration of Receipts 357

15-2d Disbursement Control 357

15-3 Marketable Securities 358

15-4 Credit Management 358

15-4a Credit Policy 359

15-4b Receivables Monitoring 359

15-4c Analyzing Proposed Changes in Credit Policy 360

15-5 Inventory Management 363

15-5a Types of Inventory 363

15-5b Optimal Inventory Level 363

15-5c Inventory Control Systems 366

15-6 Multinational Working Capital Management 367

15-6a Cash Management 367

15-6b Credit Management 367

15-6c Inventory Management 368

Key Concepts for Managing Short-Term Assets 369

Part 7 Strategic Planning and Financing Decisions

16 Financial Planning and Control 376

16-1 Projected (Pro Forma) Financial Statements 377

16-1a Step 1: Forecast the Income Statement 377

16-1b Step 2: Forecast the Balance Sheet 379

16-1c Step 3: Raising the Additional Funds Needed 380

16-1d Step 4: Accounting for Financing Feedbacks 380

16-1e Analysis of the Forecast 382

16-2 Other Considerations in Forecasting 383

16-2a Excess Capacity 383

16-2b Economies of Scale 383

16-2c Lumpy Assets 383 16-3 Financial Control-Budgeting and Leverage 384

16-3 Financial Control-Budgeting and Leverage 384

16-3a Operating Breakeven Analysis 384

16-3b Operating Leverage 387

16-3c Financial Breakeven Analysis 389

16-3d Financial Leverage 391

16-3e Combining Operating and Financial Leverage-Degree of Total Leverage (DTL) 392

16-4 Using Leverage and Forecasting for Control 393

Key Financial Planning and Control Concepts 395

Appendix A Using Spreadsheets to Solve Financial Problems 403

A-1 Setting Up Mathematical Relationships 403

A-2 Solving Time Value of Money (TVM) Problems Using Preprogrammed Spreadsheet Functions 404

A-2a Solving for Future Value (FV): Lump-Sum Amount and Annuity 405

A-2b Solving for Present Value (PV): Lump-Sum Amount and Annuity 407

A-2c Solving for r: Lump-Sum Amount and Annuity 408

A-2d Solving for n: Lump-Sum Amount and Annuity 408

A-2e Solving for Present Value and Future Value: Uneven Cash Flows 409

A-2f Setting Up an Amortization Schedule 410

Appendix B Solutions to Practice Problems 413

Index 443

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