Financial Management - GBV

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Eleventh Edition

Financial Management Principles and Applications

Sheridan Titman University of Texas at Austin Walter W. McAllister Centennial Chair in Financial Services

Arthur J. Keowrt Virginia Polytechnic Institute and State University R.B. Pamplin Professor of Finance

John D. Martin Baylor University Carr P. Collins Chair in Finance

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

Contents Preface

xviii

P a r t i °* Introduction to Financial Management CHAPTER 1

Getting Started—Principles of Finance 2 B PRINCIPLE 1: Money Has a Time Value B PRINCIPLE 2: There Is a Risk-Return Tradeoff 0 PRINCIPLE 3: Cash Flows Are the Source of Value E9 PRINCIPLE 4: Market Prices Reflect Information 1.1

Finance: An Overview 4 What Is Finance? 4 Why Study Finance? 4

1.2

Three Types of Business Organizations 5 Sole Proprietorship 5 Partnership 6 Corporation 7 How Does Finance Fit into the Firm's Organizational Structure?

/ 1.3

8

The Goal of the Financial Manager 9 Maximizing Shareholder Wealth 9 Ethical and Agency Considerations in Corporate Finance 10

1.4

The Four Basic Principles of Finance 11 Principle 1: Money Has a Time Value 12 Principle 2: There Is a Risk-Return Tradeoff 12 /Principle 3: Cash Flows Are the Source of Value 13 Principle 4: Market Prices Reflect Information 13 Chapter Summary 14 Study Questions 16 Appendix: The Wall Street Journal Workplace-Ethics Quiz 16 CHAPTER 2

Firms and the Financial Market 18 B PRINCIPLE 2: There Is a Risk-Return Tradeoff B PRINCIPLE 4: Market Prices Reflect Information 2.1

The Basic Structure of the U.S. Financial Markets

2.2

The Financial Marketplace: Financial Institutions 20 Commercial Banks: Everyone's Financial Marketplace 21 Non-Bank Financial Intermediaries 22 Investment Companies 23 THE BUSINESS OF LIFE: Controlling Costs in Mutual Funds

20

2.3

The Financial Marketplace: Securities Markets 26 How Securities Markets Bring Corporations and Investors Together Types of Securities 27

25 26

FINANCE IN A FLAT WORLD: Where's the Money around the World Chapter Summary

33

Study Questions 35

30

VI

CONTENTS CHAPTER 3

Understanding Financial Statements, Taxes, and Cash Flows 36 B PRINCIPLE 1: Money Has a Time Value S3 PRINCIPLE 3: Cash Flows Are the Source of Value B PRINCIPLE 4: Market Prices Reflect Information 3.1

An Overview of the Firm's Financial Statements 38 Basic Financial Statements 38 Why Study Financial Statements? 39 What Are the Accounting Principles Used to Prepare Financial Statements?

3.2

The Income Statement 40 Income Statement of H. J. Boswell, Inc. 40 Connecting the Income Statement and Balance Sheet 42 Interpreting Firm Profitability Using the Income Statement 42 GAAP and Earnings Management 43

3.3

Corporate Taxes 45 Computing Taxable Income 45 Federal Income Tax Rates for Corporate Income 45 Marginal and Average Tax Rates 46 Dividend Exclusion for Corporate Stockholders 46

3.4 -

The Balance Sheet 47 The Balance Sheet of H. J. Boswell, Inc. 47 Firm Liquidity and Net Working Capital 50 Debt and Equity Financing 51 Book Values, Historical Costs, and Market Values 53 THE BUSINESS OF LIFE: Your Personal Balance Sheet and Income Statement 54

3.5

The Cash Flow Statement 55 Sources and Uses of Cash 56 H. J. Boswell's Cash Flow Statement 58 FINANCE IN A FLAT WORLD: GAAPvs. IFRS

Chapter Summary

39

58

62

Study Questions 65 Self-Test Problems 66 Study Problems 69 Mini-Case 72 CHAPTER 4

Financial Analysis—Sizing Up Firm Performance

74

S PRINCIPLE 3: Cash Flows Are the Source of Value B PRINCIPLE 4: Market Prices Reflect Information 4.1

Why Do We Analyze Financial Statements?

4.2

Common Size Statements: Standardizing Financial Information 77 The Common Size Income Statement: H. J. Boswell, Inc. 77 The Common Size Balance Sheet: H. J. Boswell, Inc. 78 Using Financial Ratios 79 Liquidity Ratios 79 Capital Structure Ratios 84 Asset Management Efficiency Ratios 85 Profitability Ratios 88 Market Value Ratios 94

4.3

76

THE BUSINESS OF LIFE: Your Cash Budget and Personal Savings Ratio FINANCE IN A FLAT WORLD: Ratios and International Accounting Standards 98 Summing Up the Financial Analysis of H. J. Boswell, Inc. 99

96

CONTENTS 4.4

Selecting a Performance Benchmark Trend Analysis 101 Peer Firm Comparisons 101 4.5 Limitations of Ratio Analysis 102 Chapter Summary 104 'Study Questions 107 Self-Test Problems 107 Study Problems 113 Mini-Case 125

99

Part 2i Valuation of Financial Assets CHAPTER 5

Time Value of Money—The Basics

126

Q PRINCIPLE 1: Money Has a Time Value 5.1 Using Timelines to Visualize Cash Flows 128 5.2 Compounding and Future Value 130 I Compound Interest and Time 131 Compound Interest and the Interest Rate 131 Techniques for Moving Money through Time 131 Applying Compounding to Things Other Than Money 133 Compound Interest with Shorter Compounding Periods 133 THE BUSINESS OF LIFE: Saving for Your First House 137 5.3 Discounting and Present Value 137 The Mechanics of Discounting Future Cash Flows 138 Two Additional Types of Discounting Problems 140 The Rule of 72 141 5.4 Making Interest Rates Comparable 144 Calculating the Interest Rate and Converting It to an EAR 146 To the Extreme: Continuous Compounding 146 FINANCE IN A FLAT WORLD: Financial Access at Birth 147 Chapter Summary 148 Study Questions 150 Self-Test Problems 151 Study Problems 153 Mini-Case 157 CHAPTER 6

The Time Value of Money—Annuities and Other Topics Q PRINCIPLE 1: Money Has a Time Value 0 PRINCIPLE 3: Cash Flows Are the Source of Value 6.1 Annuities 160 Ordinary Annuities 160 Amortized Loans 168 Annuities Due 169 THE BUSINESS OF LIFE: Saving for Retirement 172 6.2 Perpetuities 173 Calculating the Present Value of a Level Perpetuity 173 Calculating the Present Value of a Growing Perpetuity 173 6.3 Complex Cash Flow Streams 176

158

VII

CONTENTS 10.2 The Comparables Approach to Valuing Common Stock 312 Defining the P/E Ratio Valuation Model 312 What Determines the P/E Ratio for a Stock? 313 An Aside on Managing for Shareholder Value 316 A Word of Caution about P/E Ratios 316 Preferred Stock 317 Features of Preferred Stock 317 Valuing Preferred Stock 318 A Quick Review: Valuing Bonds, Preferred Stock, and Common Stock 319 10.4 The Stock Market 322 Organized Exchanges 322 Over-the-Counter (OTC) Market 323 Chapter Summary 324 Study Questions 326 Self-Test Problems 327 Study Problems 329 Mini-Case 331

Part 3s Capital Budgeting CHAPTER 11

Investment Decision Criteria

332

• PRINCIPLE 1: Money Has a Time Value Q PRINCIPLE 2: There Is a Risk-Return Tradeoff S PRINCIPLE 3: Cash Flows Are the Source of Value 11.1 An Overview of Capital Budgeting 334 / The Typical Capital-Budgeting Process 335 What Are the Sources of Good Investment Projects? 335 Types of Capital Investment Projects 335 11.2 Net Present Value 336 Why Is NPV the Right Criterion? 337 Calculating an Investment's NPV 337 Independent versus Mutually Exclusive Investment Projects 338 11.3 Other Investment Criteria 344 Profitability Index 344 Internal Rate of Return 345 Modified Internal Rate of Return 354 Payback Period 355 THE BUSINESS OF LIFE: Higher Education as an Investment in Yourself Discounted Payback Period 357 Summing Up the Alternative Decision Rules 358 11.4 A Glance at Actual Capital-Budgeting Practices 360 Chapter Summary 362 Study Questions 365 Self-Test Problems 365 Study Problems 369 Mini-Cases 375 CHAPTER 1 2

Analyzing Project Cash Flows

378

G3 PRINCIPLE 3: Cash Flows Are the Source of Value 12.1 Identifying Incremental Cash Flows

380

Guidelines for Forecasting Incremental Cash Flows 381

356

CONTENTS 12.2 Forecasting Project Cash Flows 383 Dealing with Depreciation Expense, Taxes, and Cash Flow 383 Four-Step Procedure for Calculating Project Cash Flows 384 Computing Project NPV 388 12.3 Inflation and Capital Budgeting 389 ~~':rEstimating Nominal Cash Flows 389 12.4 Replacement Project Cash Flows 390 Category 1: Initial Outlay, CF0 390 Category 2: Annual Cash Flows 390 Replacement Example 391 FINANCE IN A FLAT WORLD: Entering New Markets 395 Chapter Summary 396 Study Questions 398 Self-Test Problems 399 Study Problems 404 Mini-Cases 411 Appendix: The Modified Accelerated Cost of Recovery System 414 CHAPTER 1 3

Risk Analysis and Proj ect Evaluation RISKS

416

H PRINCIPLE 1: Money Has a Time Value • PRINCIPLE 2: There Is a Risk-Return Tradeoff 0 PRINCIPLE 3: Cash Flows Are the Source of Value 13.1 The Importance of Risk Analysis 418 13.2 Tools for Analyzing the Risk of Project Cash Flows 419 Key Concepts: Expected Values and Value Drivers 419 Sensitivity Analysis 421 Scenario Analysis 425 Simulation Analysis 426 FINANCE IN A FLAT WORLD: Currency Risk 429 13.3 Break-Even Analysis 429 Accounting Break-Even Analysis 429 NPV Break-Even Analysis 434 Operating Leverage and the Volatility of Project Cash Flows 436 13.4 Real Options in Capital Budgeting 438 The Option to Delay the Launch of a Project 438 The Option to Expand a Project 438 The Option to Reduce the Scale and Scope of a Project 440 Chapter Summary 441 Study Questions 443 Self-Test Questions 443 Study Problems 446 Mini-Case 451 CHAPTER 1 4

The Cost of Capital B • B 0

PRINCIPLE PRINCIPLE PRINCIPLE PRINCIPLE

1: 2: 3: 4:

452

Money Has a Time Value There Is a Risk-Return Tradeoff Cash Flows Are the Source of Value Market Prices Reflect Information

XI

XII

CONTENTS 14.1 The Cost of Capital: An Overview 454 Investor's Required Return and the Firm's Cost of Capital WACC Equation 455 Three-Step Procedure for Estimating Firm WACC 456 14.2 Determining the Firm's Capital Structure Weights

458

' 14.3 Estimating the Cost of Individual Sources of Capital The Cost of Debt 461 The Cost of Preferred Equity 461 The Cost of Common Equity 464 14.4 Summing Up: Calculating the Firm's WACC 470 Use Market-Based Weights 470 Use Market-Based Opportunity Costs 470 Use Forward-Looking Weights and Opportunity Costs

455

460

471

14.5 Estimating Project Costs of Capital 471 The Rationale for Using Multiple Discount Rates 471 Why Don't Firms Typically Use Project Costs of Capital? 472 Estimating Divisional WACCS 472 Divisional WACC: Estimation Issues and Limitations 473 FINANCE IN A FLAT WORLD: Why Do Interest Rates Differ Between Countries? 474 ; 14.6 Flotation Costs and Project NPV

475

WACC, Flotation Costs, and NPV 476 Chapter Summary Study Questions

479 481

Self-Test Problems Study Problems Mini-Case

482

485

489

Part 4: Capital Structure and Dividend Policy CHAPTER 15

Capital Structure Policy •

490

PRINCIPLE 2: There Is a Risk-Return Tradeoff

E3 PRINCIPLE 3: Cash Flows Are the Source of Value 15.1 A Glance at Capital Structure Choices in Practice 492 Defining a Firm's Capital Structure 492 Financial Leverage 494 How Do Firms in Different Industries Finance Their Assets? 494 15.2 Capital Structure Theory 495 A First Look at the Modigliani and Miller Capital Structure Theorem 495 Yogi Berra and the M&M Capital Structure Theory 497 Capital Structure, the Cost of Equity, and the Weighted Average Cost of Capital 497 Why Capital Structure Matters in Reality 499 Making Financing Choices When Managers Are Better Informed than Shareholders 504 Managerial Implications 505 15.3 Why Do Capital Structures Differ across Industries?

506

15.4 Making Financing Decisions 507 Benchmarking the Firm's Capital Structure 507 Evaluating the Effect of Financial Leverage on Firm Earnings per Share Can the Firm Afford More Debt? 515 Survey Evidence: Factors That Influence CFO Debt Policy 516

508

FINANCE IN A FLAT WORLD: Capital Structures around the World

517

CONTENTS Chapter Summary Study Questions

518 520

Self-Test Problems Study Problems ..Mini-Case

522

525

529

Appendix: Demonstrating the Modigliani and Miller Theorem

530

CHAPTER 16 Alternative #1

Dividend Policy

534

B PRINCIPLE 1: Money Has a Time Value 0 PRINCIPLE 3: Cash Flows Are the Source of Value E3 PRINCIPLE 4: Market Prices Reflect Information 16.1 How Do Firms Distribute Cash to Their Shareholders? 536 Cash Dividends 537 Stock Repurchases 538 Personal Tax Considerations: Dividend versus Capital Gains Income Non-Cash Distributions: Stock Dividends and Stock Splits 539

Alternative «3

16.2 Does Dividend Policy Matter? 540 The Irrelevance of the Distribution Choice ,' Why Dividend Policy Is Important 546

540

THE BUSINESS OF LIFE: The Importance of Dividends 16.3 Cash Distribution Policies in Practice 549 Stable Payout 549 Residual Dividend Payout Policy 553 Other Factors Playing a Role in How Much to Distribute

553

FINANCE IN A FLAT WORLD: Dividends Abroad

554

Chapter Summary Study Questions

Mini-Case

549

555 557

Self-Test Problem Study Problems

539

558 559

561

Part 5; Liquidity Management and Special Topics in Finance CHAPTER 17

Financial Forecasting and Planning •

562

PRINCIPLE 2: There Is a Risk-Return Tradeoff 17.1 An Overview of Financial Planning

564

17.2 Developing a Long-Term Financial Plan 565 Financial Forecasting Example: Ziegen, Inc. 566 THE BUSINESS OF LIFE: Your Personal Budget 17.3 Developing a Short-Term Financial Plan 574 Example Cash Budget: Melco Furniture, Inc. 574 Uses of the Cash Budget 574 Chapter Summary Study Questions

576 577

Self-Test Problems Study Problems Mini-Case

587

578

581

571

XIII

XIV

CONTENTS CHAPTER 1 8

Working Capital Management

588

• PRINCIPLE 2: There Is a Risk-Return Tradeoff 18.1 Working Capital Management and the Risk-Return Tradeoff —_-:jMeasuring Firm Liquidity 590 Managing Firm Liquidity 591 Risk-Return Tradeoff 591 18.2 Working Capital Policy 593 The Principle of Self-Liquidating Debt 593 A Graphic Illustration of the Principle of Self-Liquidating Debt 18.3 Operating and Cash Conversion Cycles 595 Measuring Working Capital Efficiency 596 Calculating the Operating and Cash Conversion Cycle 18.4 Managing Current Liabilities 600 Calculating the Cost of Short-Term Financing Evaluating the Cost of Trade Credit 601 Evaluating the Cost of Bank Loans 602

THE BUSINESS OF LIFE: Credit Scoring Managing Inventories 609

Chapter Summary Study Questions

Mini-Case

597

604

608

610 612

Self-Test Problems Study Problems

595

601

18.5 Managing the Firm's Investment in Current Assets Cash and Marketable Securities 604 i Managing Accounts Receivable 605 '--

590

613

616

619

CHAPTER 1 9

International Business Finance

620

S PRINCIPLE 2: There Is a Risk-Return Tradeoff E3 PRINCIPLE 3: Cash Flows Are the Source of Value 19.1 Foreign Exchange Markets and Currency Exchange Rates Foreign Exchange Rates 622 Types of Foreign Exchange Transactions 627 19.2 Interest Rate and Purchasing-Power Parity 630 Interest Rate Parity 630 Purchasing-Power Parity and the Law of One Price 630 The International Fisher Effect 631 19.3 Capital Budgeting for Direct Foreign Investment 633 THE BUSINESS OF LIFE: International Investing 634 Foreign Investment Risks 638 Chapter Summary Study Questions

640 642

Self-Test Problems Study Problems Mini-Case

647

643

644

622

CONTENTS CHAPTER 2 0

Corporate Risk Management •

648

PRINCIPLE 2: There Is a Risk-Return Tradeoff 20.1 Five-Step Corporate Risk Management Process 650 ~ -_-:_-- Step 1: Identify and Understand the Firm's Major Risks 650 Step 2: Decide Which Types of Risks to Keep and Which to Transfer 651 Step 3: Decide How Much Risk to Assume 651 Step 4: Incorporate Risk into All the Firm's Decisions and Processes 651 Step 5: Monitor and Manage the Risks the Firm Assumes 652 20.2 Managing Risk with Insurance Contracts 653 Types of Insurance Contracts 653 Why Purchase Insurance? 653

THE BUSINESS OF LIFE: Do You Need Life Insurance?

654

20.3 Managing Risk by Hedging with Forward Contracts 654 Hedging Commodity Price Risk Using Forward Contracts 655 Hedging Currency Risk Using Forward Contracts 655 20.4 Managing Risk with Exchange-Traded Financial Derivatives Futures Contracts 660 Options Contracts 661 20.5 Valuing Options and Swaps 667 1The Black-Scholes Option Pricing Model Swap Contracts 672 Chapter Summary Study Questions

674 676

Self-Test Problems Study Problems Mini-Case

682

Appendixes A-1 Glossary G-l Indexes 1-1

677

680

668

659

XV

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Financial Management - GBV

Eleventh Edition Financial Management Principles and Applications Sheridan Titman University of Texas at Austin Walter W. McAllister Centennial Chai...

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