Principles of Managerial Finance (13th Edition)

Principles of

Managerial Finance

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Principles of

Managerial Finance Thirteenth Edition

Lawrence J. Gitman San Diego State University

Chad J. Zutter University of Pittsburgh

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Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text (or on page C1). Microsoft® and Windows® are registered trademarks of the Microsoft Corporation in the U.S.A. and other countries. Screen shots and icons reprinted with permission from the Microsoft Corporation. This book is not sponsored or endorsed by or affiliated with the Microsoft Corporation. Copyright © 2012, 2009, 2006, 2003 by Lawrence J. Gitman. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617 671-3447, or e-mail at http://www.pearsoned.com/legal/permission.htm. Many of the designations by manufactures and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. Library of Congress Cataloging-in-Publication Data Gitman, Lawrence J. Principles of managerial finance/Lawrence J. Gitman, Chad J. Zutter.—13th ed. p. cm.—(The Prentice Hall series in finance) Includes index. ISBN 978-0-13-611946-3 (alk. paper) 1. Corporations—Finance. 2. Business enterprises—Finance. I. Zutter, Chad J. II. Title. HG4011.G52 2010 658.15—dc22 2010044526

Prentice Hall is an imprint of ISBN-13: 978-0-13-611946-3 ISBN-10: 0-13-611946-8

Dedicated to the memory of my mother, Dr. Edith Gitman, who instilled in me the importance of education and hard work. LJG

Dedicated to my wonderful wife, Heidi Zutter, who unconditionally supports my every endeavor. CJZ

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Our Proven Teaching and Learning System

sers of Principles of Managerial Finance have praised the effectiveness of the book’s Teaching and Learning System, which they hail as one of its hallmarks. The system, driven by a set of carefully developed learning goals, has been retained and polished in this thirteenth edition. The “walkthrough” on the pages that follow illustrates and describes the key elements of the Teaching and Learning System. We encourage both students and instructors to acquaint themselves at the start of the semester with the many useful features the book offers.

U

1

The Role of Managerial Finance

Learning Goals

Why This Chapter Matters to You

LG 1 Define finance and the

In your professional life

managerial finance function.

LG 2 Describe the legal forms of

business organization.

LG 3 Describe the goal of the firm, and

explain why maximizing the value of the firm is an appropriate goal for a business.

LG 4 Describe how the managerial

finance function is related to economics and accounting.

LG 5 Identify the primary activities of

the financial manager.

LG 6 Describe the nature of the

principal–agent relationship between the owners and managers of a corporation, and explain how various corporate governance mechanisms attempt to manage agency problems.

ACCOUNTING You need to understand the relationships between the accounting and finance functions within the firm; how decision makers rely on the financial statements you prepare; why maximizing a firm’s value is not the same as maximizing its profits; and the ethical duty that you have when reporting financial results to investors and other stakeholders. INFORMATION SYSTEMS You need to understand why financial information is important to managers in all functional areas; the documentation that firms must produce to comply with various regulations; and how manipulating information for personal gain can get managers into serious trouble. MANAGEMENT You need to understand the various legal forms of a business organization; how to communicate the goal of the firm to employees and other stakeholders; the advantages and disadvantages of the agency relationship between a firm’s managers and its owners; and how compensation systems can align or misalign the interests of managers and investors. MARKETING You need to understand why increasing a firm’s revenues or market share is not always a good thing; how financial managers evaluate aspects of customer relations such as cash and credit management policies; and why a firm’s brands are an important part of its value to investors. OPERATIONS You need to understand the financial benefits of increasing a firm’s production efficiency; why maximizing profit by cutting costs may not increase the firm’s value; and how managers act on behalf of investors when operating a corporation. Many of the principles of manageIn your life rial finance also apply to your personal life. Learning a few simple financial principles can help you manage your own money more effectively.

personal

2

Six Learning Goals at the start of the chapter highlight the most important concepts and techniques in the chapter. Students are reminded to think about the learning goals while working through the chapter by strategically placed learning goal icons. Every chapter opens with a feature, titled Why This Chapter Matters to You, that helps motivate student interest by highlighting both professional and personal benefits from achieving the chapter learning goals. Its first part, In Your Professional Life, discusses the intersection of the finance topics covered in the chapter with the concerns of other major business disciplines. It encourages students majoring in accounting, information systems, management, marketing, and operations to appreciate how financial acumen will help them achieve their professional goals. The second part, In Your Personal Life, identifies topics in the chapter that will have particular application to personal finance. This feature also helps students appreciate the tasks performed in a business setting by pointing out that the tasks are not necessarily different from those that are relevant in their personal lives.

vii

Each chapter begins with a short opening vignette that describes a recent real-company event related to the chapter topic. These stories raise interest in the chapter by demonstrating its relevance in the business world.

Facebook In No Hurry to Go Public

F

acebook founder and chief executive officer Mark Zuckerberg is in no hurry to go public, even

though he concedes that it is an inevitable step in the evolution of his firm. The Facebook CEO is on record saying that “we’re going to go public eventually, because that’s the contract that we have with our investors and our employees. . . . [but] we are definitely in no rush.” Nearly all public firms were at one time privately held by relatively few shareholders, but at some point the firms’ managers decided to go public. The decision to go public is one of the most important decisions managers can make. Private firms are typically held by fewer shareholders and are subject to less regulation than are public firms. So why do firms go public at all? Often it is to provide an exit strategy for its private investors, gain access to investment capital, establish a market price for the firm’s shares, gain public exposure, or all of the above. Going public helps firms grow, but that and other benefits of public ownership must be weighed against the costs of going public. Although taking Facebook public would likely make Zuckerberg one of the richest persons in the world under the age of 30, it would also mean that his firm would become subject to the influences of outside investors and government regulators. A public firm’s managers work for and are responsible to the firm’s investors, and government regulations require firms to provide investors with frequent reports disclosing material information about the firm’s performance. The regulatory demands placed on managers of public firms can sometimes distract managers from important aspects of running their businesses. This chapter will highlight the tradeoffs faced by financial managers as they make decisions intended to maximize the value of their firms.

3

Learning goal icons tie chapter content to the learning goals and appear next to related text sections and again in the chapter-end summary, end-ofchapter homework materials, and supplements such as the Study Guide, Test Item File, and MyFinanceLab.

For help in study and review, boldfaced key terms and their definitions appear in the margin where they are first introduced. These terms are also boldfaced in the book’s index and appear in the endof-book glossary.

viii

LG 1

LG 2

1.1 Finance and Business The field of finance is broad and dynamic. Finance influences everything that firms do, from hiring personnel to building factories to launching new advertising campaigns. Because there are important financial dimensions to almost any aspect of business, there are many financially oriented career opportunities for those who understand the basic principles of finance described in this textbook. Even if you do not see yourself pursuing a career in finance, you’ll find that an understanding of a few key ideas in finance will help make you a smarter consumer and a wiser investor with your own money.

Corporations corporation An entity created by law.

stockholders The owners of a corporation, whose ownership, or equity, takes the form of either common stock or preferred stock.

A corporation is an entity created by law. A corporation has the legal powers of an individual in that it can sue and be sued, make and be party to contracts, and acquire property in its own name. Although only about 20 percent of all U.S. businesses are incorporated, the largest businesses nearly always are; corporations account for nearly 90 percent of total business revenues. Although corporations engage in all types of businesses, manufacturing firms account for the largest portion of corporate business receipts and net profits. Table 1.1 lists the key strengths and weaknesses of corporations.

Matter of Fact boxes provide interesting empirical facts that add background and depth to the material covered in the chapter.

Matter of fact Problems with P/E Valuation

T

he P/E multiple approach is a fast and easy way to estimate a stock’s value. However, P/E ratios vary widely over time. In 1980, the average stock had a P/E ratio below 9, but by the year 2000, the ratio had risen above 40. Therefore, analysts using the P/E approach in the 1980s would have come up with much lower estimates of value than analysts using the model 20 years later. In other words, when using this approach to estimate stock values, the estimate will depend more on whether stock market valuations generally are high or low rather than on whether the particular company is doing well or not.

In more depth P0 =

To read about Deriving the Constant-Growth Model, go to www.myfinancelab.com

D0 * (1 + g)1 (1 + rs)

1

+

D0 * (1 + g)2 (1 + rs)

2

D0 * (1 + g) + Á + q (1 + rs)

If we simplify Equation 7.3, it can be rewritten as:

Example

6.3

3

The nominal interest rates on a number of classes of long-term securities in May 2010 were as follows:

Security

Nominal interest rate

U.S. Treasury bonds (average) Corporate bonds (by risk ratings): High quality (Aaa–Aa) Medium quality (A–Baa) Speculative (Ba–C)

3.30% 3.95 4.98 8.97

Because the U.S. Treasury bond would represent the risk-free, long-term security, we can calculate the risk premium of the other securities by subtracting the riskfree rate, 3.30%, from each nominal rate (yield):

Security

Risk premium

Corporate bonds (by ratings): High quality (Aaa–Aa) Medium quality (A–Baa) Speculative (Ba–C)

5.7

3

Time line for future value of an ordinary annuity ($1,000 end-of-year deposit, earning 7%, at the end of 5 years)

$1,310.80 1,225.04 1,144.90 1,070.00 1,000.00 $5,750.74 Future Value $1,000

$1,000

$1,000

(7.3)

Examples are an important component of the book’s learning system. Numbered and clearly set off from the text, they provide an immediate and concrete demonstration of how to apply financial concepts, tools, and techniques. Some Examples demonstrate time-valueof-money techniques. These examples often show the use of time lines, equations, financial calculators, and spreadsheets (with cell formulas).

3.95% - 3.30% = 0.65% 4.98 - 3.30 = 1.68 8.97 - 3.30 = 5.67

Fran Abrams wishes to determine how much money she will have at the end of 5 years if she chooses annuity A, the ordinary annuity. She will deposit $1,000 annually, at the end of each of the next 5 years, into a savings account paying 7% annual interest. This situation is depicted on the following time line:

Personal Finance Example

q

In More Depth boxes point students to additional material, available on MyFinanceLab, intended to further highlight a particular topic for students who want to explore a topic in greater detail.

$1,000

$1,000

The Equation for Present Value

The present value of a future amount can be found mathematically by solving Equation 5.4 for PV. In other words, the present value, PV, of some future amount, FVn, to be received n periods from now, assuming an interest rate (or opportunity cost) of r, is calculated as follows: PV =

Personal Finance Examples demonstrate how students can apply managerial finance concepts, tools, and techniques to their personal financial decisions.

FVn (1 + r)n

(5.7)

Note the similarity between this general equation for present value and the equation in the preceding example (Equation 5.6). Let’s use this equation in an example.

Key equations appear in green boxes throughout the text to help readers identify the most important mathematical relationships. The variables used in these equations are, for convenience, printed on the back endpapers of the book.

ix

Review Questions appear at the end of each major text section. These questions challenge readers to stop and test their understanding of key concepts, tools, techniques, and practices before moving on to the next section.

In Practice boxes offer insights into important topics in managerial finance through the experiences of real companies, both large and small. There are three categories of In Practice boxes: Focus on Ethics boxes in every chapter help readers understand and appreciate important ethical issues and problems related to managerial finance. Focus on Practice boxes take a corporate focus that relates a business event or situation to a specific financial concept or technique. Global Focus boxes look specifically at the managerial finance experiences of international companies. All three types of In Practice boxes end with one or more critical thinking questions to help readers broaden the lesson from the content of the box.

6

REVIEW QUESTIONS 5–14 What effect does compounding interest more frequently than annually

have on (a) future value and (b) the effective annual rate (EAR)? Why? 5–15 How does the future value of a deposit subject to continuous com-

pounding compare to the value obtained by annual compounding? 5–16 Differentiate between a nominal annual rate and an effective annual

rate (EAR). Define annual percentage rate (APR) and annual percentage yield (APY).

focus on ETHICS If It Seems Too Good to Be True Then It Probably Is fraud. Madoff’s hedge fund, Ascot Madoff’s arrest indicated that investors’ in practice For many years, Partners, turned out to be a giant Ponzi accounts contained over $64 billion, in investors around the scheme. aggregate. Many investors pursued world clamored to invest with Bernard Over the years, suspicions were claims based on the balance reported Madoff. Those fortunate enough to raised about Madoff. Madoff generin these statements. However, a recent invest with “Bernie” might not have ated high returns year after year, seem- court ruling permits claims up to the difunderstood his secret trading system, ingly with very little risk. Madoff ference between the amount an investor but they were happy with the doublecredited his complex trading strategy deposited with Madoff and the amount digit returns that they earned. Madoff for his investment performance, but they withdrew. The judge also ruled was well connected, having been the other investors employed similar stratethat investors who managed to withchairman of the board of directors of gies with much different results than draw at least their initial investment the NASDAQ Stock Market and a Madoff reported. Harry Markopolos before the fraud was uncovered are not founding member of the International focusClearing on Corporation. His went as far as to submit a report to the eligible to recover additional funds. Securities SEC three years prior to Madoff’s arrest Total out-of-pocket cash losses as a credentials seemed to be impeccable. However, the old saying goes, if titled “The World’s Largest Hedge Fund result of Madoff’s fraud were recently Limitsason Payback Analysis something sounds too good to be true, Is a Fraud” that detailed his concerns.a estimated at slightly over $20 billion. In investors tough economic in Barrington, Illinois.Madoff “The simplicity of even more important than discounted it probably is. Madoff’s On June 29, 2009, was in practice of the standard computing payback encourage 3 What cash are flowsome (NPV hazards and IRR)—because it learned this lesson thetimes, hard way when, for sentenced to 150 years inmay prison. allowing investors to pursue a payback period is often reduced. Madoff’s sloppiness, especially the failure spotlights the risks inherent in lengthy IT on December 11, 2008, the U.S. investors are still working to to claims based“Ittheir most recent Chief information officers (CIOs) are include all costs associated with an projects. should be a hard and fast Securities and Exchange Commission recover what they can. Fraudulent to reject projects with payback account investment, such as just training, mainte- accounts rule tostatements? never take an IT project with a (SEC)apt charged Madoff with securities statements sent prior to periods of more than 2 years. “We nance, and hardware upgrade costs,” payback period greater than 3 years, a start with payback period,” says says Douglas Emond, senior vice presi- unless it’s an infrastructure project you Ron Fijalkowski, CIO at Strategic dent and chief technology officer at can’t do without,” Campbell says. Distribution, Inc., in Bensalem, Eastern Bank in Lynn, Massachusetts. Whatever the weaknesses of the Pennsylvania. “For sure, if the payback For example, he says, “you may be payback period method of evaluating period is over 36 months, it’s not going bringing in a hot new technology, but capital projects, the simplicity of the to get approved. But our rule of thumb uh-oh, after implementation you realize method does allow it to be used in is we’d like to see 24 months. And if that you need a dot-net guru in-house, conjunction with other, more sophistiit’s close to 12, it’s probably a noand you don’t have one.” cated measures. It can be used to brainer.” But the payback method’s emphasis screen potential projects and winnow While easy to compute and easy on the short term has a special appeal them down to the few that merit more to understand, the payback periods sim- for IT managers. “That’s because the careful scrutiny with, for example, net plicity brings with it some drawbacks. history of IT projects that take longer present value (NPV). “Payback gives you an answer that tells than 3 years is disastrous,” says 3 In your view, if the payback period you a bit about the beginning stage of Gardner. Indeed, Ian Campbell, chief method is used in conjunction with a project, but it doesn’t tell you much research officer at Nucleus Research, the NPV method, should it be used about the full lifetime of the project,” Inc., in Wellesley, Massachusetts, says before or after the NPV evaluation? says Chris Gardner, a cofounder of payback period is an absolutely esseniValue LLC, an IT valuation consultancy tial metric for evaluating IT projects—

PRACTICE

GLOBAL focus An International Flavor to Risk Reduction in practice Earlier in this chapter (see Table 8.5 on page 318), we learned that from 1900 through 2009 the U.S. stock market produced an average annual nominal return of 9.3 percent, but that return was associated with a relatively high standard deviation: 20.4 percent per year. Could U.S. investors have done better by diversifying globally? The answer is a qualified yes. Elroy Dimson, Paul Marsh, and Mike

Staunton calculated the historical returns on a portfolio that included U.S. stocks as well as stocks from 18 other countries. This diversified portfolio produced returns that were not quite as high as the U.S. average, just 8.6 percent per year. However, the globally diversified portfolio was also less volatile, with an annual standard deviation of 17.8 percent. Dividing the standard deviation by the annual return produces a coefficient of variation for the globally

diversified portfolio of 2.07, slightly lower than the 2.10 coefficient of variation reported for U.S. stocks in Table 8.5. 3 International mutual funds do not include any domestic assets whereas global mutual funds include both foreign and domestic assets. How might this difference affect their correlation with U.S. equity mutual funds?

Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton University Press, 2002).

x

Summary FOCUS ON VALUE Time value of money is an important tool that financial managers and other market participants use to assess the effects of proposed actions. Because firms have long lives and some decisions affect their long-term cash flows, the effective application of time-value-of-money techniques is extremely important. These techniques enable financial managers to evaluate cash flows occurring at different times so as to combine, compare, and evaluate them and link them to the firm’s overall goal of share price maximization. It will become clear in Chapters 6 and 7 that the application of time value techniques is a key part of the value determination process needed to make intelligent value-creating decisions.

REVIEW OF LEARNING GOALS LG 1

Discuss the role of time value in finance, the use of computational tools, and the basic patterns of cash flow. Financial managers and investors use timevalue-of-money techniques when assessing the value of expected cash flow streams. Alternatives can be assessed by either compounding to find future value or discounting to find present value. Financial managers rely primarily on present value techniques. Financial calculators, electronic spreadsheets, and financial tables can streamline the application of time value techniques. The cash flow of a firm can be described by its pattern—single amount, annuity, or mixed stream.

Opener-in-Review In the chapter opener you learned that it costs Eli Lilly close to $1 billion to bring a new drug to market, and by the time all of the R&D and clinical trials are completed, Lilly may have fewer than 10 years left to sell the drug under patent protection. Assume that the $1 billion cost of bringing a new drug to market is spread out evenly over 10 years, and then 10 years remain for Lilly to recover their investment. How much cash would a new drug have to generate in the last 10 years to justify the $1 billion spent in the first 10 years? Assume that Lilly uses a required rate of return of 10%.

Self-Test Problems LG 2

LG 5

ST5–1

Future values for various compounding frequencies Delia Martin has $10,000 that she can deposit in any of three savings accounts for a 3-year period. Bank A compounds interest on an annual basis, bank B compounds interest twice each year, and bank C compounds interest each quarter. All three banks have a stated annual interest rate of 4%. a. What amount would Ms. Martin have at the end of the third year, leaving all interest paid on deposit, in each bank? b. What effective annual rate (EAR) would she earn in each of the banks? c. On the basis of your findings in parts a and b, which bank should Ms. Martin deal with? Why? d. If a fourth bank (bank D), also with a 4% stated interest rate, compounds interest continuously, how much would Ms. Martin have at the end of the third year? Does this alternative change your recommendation in part c? Explain why or why not.

Warm-Up Exercises

LG 2

(Solutions in Appendix)

All problems are available in

.

LG 2

E5–1

Assume a firm makes a $2,500 deposit into its money market account. If this account is currently paying 0.7% (yes, that’s right, less than 1%!), what will the account balance be after 1 year?

LG 5

E5–2

If Bob and Judy combine their savings of $1,260 and $975, respectively, and deposit this amount into an account that pays 2% annual interest, compounded monthly, what will the account balance be after 4 years?

The end-of-chapter Summary consists of two sections. The first section, Focus on Value, explains how the chapter’s content relates to the firm’s goal of maximizing owner wealth. The feature helps reinforce understanding of the link between the financial manager’s actions and share value. The second part of the Summary, the Review of Learning Goals, restates each learning goal and summarizes the key material that was presented to support mastery of the goal. This review provides students with an opportunity to reconcile what they have learned with the learning goal and to confirm their understanding before moving forward.

An Opener-in-Review question at the end of each chapter revisits the opening vignette and asks students to apply a lesson from the chapter to that business situation. Self-Test Problems, keyed to the learning goals, give readers an opportunity to strengthen their understanding of topics by doing a sample problem. For reinforcement, solutions to the SelfTest Problems appear in the appendix at the back of the book.

Warm-Up Exercises follow the SelfTest Problems. These short, numerical exercises give students practice in applying tools and techniques presented in the chapter.

xi

Problems

All problems are available in

Using a time line The financial manager at Starbuck Industries is considering an investment that requires an initial outlay of $25,000 and is expected to result in cash inflows of $3,000 at the end of year 1, $6,000 at the end of years 2 and 3, $10,000 at the end of year 4, $8,000 at the end of year 5, and $7,000 at the end of year 6. a. Draw and label a time line depicting the cash flows associated with Starbuck Industries’ proposed investment. b. Use arrows to demonstrate, on the time line in part a, how compounding to find future value can be used to measure all cash flows at the end of year 6. c. Use arrows to demonstrate, on the time line in part b, how discounting to find present value can be used to measure all cash flows at time zero. Integrative—Pro statements future Red Queen wishesdo tofinancial prepare managers d Which offorma the approaches value Restaurants or present value financial plans. Use the financial statements on page 155 and the other information provided below to prepare the financial plans.

P5–1

LG 1

LG 5

.

P4–19

Personal Finance Problem

LG 2

P5–7

LG 6

Time value You can deposit $10,000 into an account paying 9% annual interest either today or exactly 10 years from today. How much better off will you be at the end of 40 years if you decide to make the initial deposit today rather than 10 years from today?

P5–62

ETHICS PROBLEM A manager at a “Check Into Cash” business (see Focus on Ethics box on page 192) defends his business practice as simply “charging what the market will bear.” “After all,” says the manager, “we don’t force people to come in the door.” How would you respond to this ethical defense of the payday-advance business?

Comprehensive Problems, keyed to the learning goals, are longer and more complex than the Warm-Up Exercises. In this section, instructors will find multiple problems that address the important concepts, tools, and techniques in the chapter. A short descriptor identifies the essential concept or technique of the problem. Problems labeled as Integrative tie together related topics. Personal Finance Problems specifically relate to personal finance situations and Personal Finance Examples in each chapter. These problems will help students see how they can apply the tools and techniques of managerial finance in managing their own finances. The last item in the chapter Problems is an Ethics Problem. The ethics problem gives students another opportunity to think about and apply ethics principles to managerial financial situations. All exercises and problems are available in MyFinanceLab.

Spreadsheet Exercise You are interested in purchasing the common stock of Azure Corporation. The firm recently paid a dividend of $3 per share. It expects its earnings—and hence its dividends—to grow at a rate of 7% for the foreseeable future. Currently, similar-risk stocks have required returns of 10%.

Integrative Case 1 Merit Enterprise Corp. ara Lehn, chief financial officer of Merit Enterprise Corp., was reviewing her presentation one last time before her upcoming meeting with the board of directors. Merit’s business had been brisk for the last two years, and the company’s CEO was pushing for a dramatic expansion of Merit’s production capacity. Executing the CEO’s plans would require $4 billion in capital in addition to $2 billion in excess cash that the firm had built up. Sara’s immediate task was to brief the board on options for raising the needed $4 billion. Unlike most companies its size, Merit had maintained its status as a private company, financing its growth by reinvesting profits and, when necessary, borrowing from banks. Whether Merit could follow that same strategy to raise the $4 billion necessary to expand at the pace envisioned by the firm’s CEO was uncertain, though it seemed unlikely to Sara. She had identified two options for the board to consider:

S

Every chapter includes a Spreadsheet Exercise. This exercise gives students an opportunity to use Excel® software to create one or more spreadsheets with which to analyze a financial problem. The spreadsheet to be created often is modeled on a table or Excel screenshot located in the chapter. Students can access working versions of the Excel screenshots in MyFinanceLab. An Integrative Case at the end of each part of the book challenges students to use what they have learned over the course of several chapters. Additional chapter resources, such as Chapter Cases, Group Exercises, Critical Thinking Problems, and numerous online resources, intended to provide further means for student learning and assessment are available in MyFinanceLab at www.myfinancelab.com.

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Brief Contents

Detailed Contents About the Authors Preface xxxvii Supplements to the Acknowledgments To the Student li

Part 1 1 2

Thirteenth Edition xlv xlvii

Introduction to Managerial Finance 1

The Role of Managerial Finance 2 The Financial Market Environment 30

Part 2 3 4 5

xv xxxv

Financial Tools

12

Part 6 13 14

55

Financial Statements and Ratio Analysis 56 Cash Flow and Financial Planning 113 Time Value of Money 159

6 7

Risk and the Required Rate of Return 307

Risk and Return 308 The Cost of Capital 356

Part 5 10 11

219

Interest Rates and Bond Valuation 220 Stock Valuation 264

Part 4 8 9

Valuation of Securities

Long-Term Investment Decisions 387

Capital Budgeting Techniques 388 Capital Budgeting Cash Flows 426

16

19

Short-Term Financial Decisions 597

Working Capital and Current Assets Management 598 Current Liabilities Management 640

Part 8 17 18

Long-Term Financial Decisions 505

Leverage and Capital Structure 506 Payout Policy 559

Part 7 15

Part 3

Risk and Refinements in Capital Budgeting 463

Special Topics in Managerial Finance 675

Hybrid and Derivative Securities 676 Mergers, LBOs, Divestitures, and Business Failure 714 International Managerial Finance 757

Appendix Glossary

A-1 G-1

Index I-1

xiii

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Contents About the Authors xxxv Preface xxxvii Supplements to the Thirteenth Edition xlv Acknowledgments xlvii To the Student li

Part 1

Introduction to Managerial Finance

1 The Role of Managerial Finance page 2

1.1

Finance and Business

4

What is Finance? 4 Career Opportunities in Finance 4 Legal Forms of Business Organization 5 in practice Focus on Practice: Professional Certifications in Finance 5

Why Study Managerial Finance? 9 Facebook—In No Hurry To Go Public page 3

6 REVIEW QUESTIONS

1.2

9

Goal of the Firm

Relationship to Accounting 17 Primary Activities of the Financial Manager 19 6 REVIEW QUESTIONS

1.4

10

19

Governance and Agency

20

Corporate Governance 20 The Agency Issue 21 6 REVIEW QUESTIONS

Maximize Shareholder Wealth 10 Maximize Profit? 11 What About Stakeholders? 13 The Role of Business Ethics 13 6 REVIEW QUESTIONS

1

24

Summary 24 Opener-in-Review 25 Self-Test Problem 25 Warm-Up Exercises 26 Problems 27 Spreadsheet Exercise 29

14

in practice Focus on Ethics: Will Google Live Up to Its Motto? 15

1.3 Managerial Finance Function 15

Organization of the Finance Function 16 Relationship to Economics 16

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Contents

2 The Financial Market Environment page 30

2.1 Financial Institutions and Markets 32

2.3 Regulation of Financial Institutions 44

Financial Institutions 32 Commercial Banks, Investment Banks, and the Shadow Banking System 33

Regulations Governing Financial Institutions 44

Financial Markets 34 The Relationship Between Institutions and Markets 34 The Money Market 35 The Capital Market 35 in practice Focus on Practice: Berkshire Hathaway—Can Buffett Be Replaced? 37 JPMorgan Chase & Co.— Cut to the Chase page 31

in practice Focus on Ethics: The Ethics of Insider Trading 40

6 REVIEW QUESTIONS

2.2

40

The Financial Crisis

41

Financial Institutions and Real Estate Finance 41 Falling Home Prices and Delinquent Mortgages 41 Crisis of Confidence in Banks 42 Spillover Effects and the Great Recession 43 6 REVIEW QUESTIONS

44

Regulations Governing Financial Markets 45 6 REVIEW QUESTIONS

2.4

Business Taxes

45 46

Ordinary Income 46 Capital Gains 48 6 REVIEW QUESTIONS

49

Summary 49 Opener-in-Review 50 Self-Test Problem 51 Warm-Up Exercises 51 Problems 51 Spreadsheet Exercise 53 Integrative Case 1 Merit Enterprise Corp. 54

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Contents

Part 2

Financial Tools

3 Financial Statements and Ratio Analysis page 56

3.1

55

The Stockholders’ Report

58

The Letter to Stockholders 58 in practice Global Focus: More Countries Adopt International Financial Reporting Standards 58

The Four Key Financial Statements 59 in practice Focus on Ethics: Taking Earnings Reports at Face Value 59

Notes to the Financial Statements 65 Consolidating International Financial Statements 65 6 REVIEW QUESTIONS Abercrombie & Fitch— The Value of Casual Luxury page 57

3.2

66

3.3

Using Financial Ratios

70

Liquidity Ratios

71

Current Ratio 71 Quick (Acid-Test) Ratio 72 6 REVIEW QUESTIONS

3.4

73

Activity Ratios

73

Inventory Turnover 73 Average Collection Period 74 Average Payment Period 75 Total Asset Turnover 75 6 REVIEW QUESTION

3.5

Debt Ratios

6 REVIEW QUESTIONS

3.6

76 76

Debt Ratio 77 Times Interest Earned Ratio 78

67

79

Profitability Ratios

79

Common-Size Income Statements Gross Profit Margin 79 Operating Profit Margin 80

79

Net Profit Margin 80 Earnings Per Share (EPS) 81 Return on Total Assets (ROA) 81 Return on Common Equity (ROE) 82 6 REVIEW QUESTIONS

Interested Parties 67 Types of Ratio Comparisons 67 Cautions About Using Ratio Analysis 70 Categories of Financial Ratios 70 6 REVIEW QUESTIONS

Fixed-Payment Coverage Ratio 78

3.7

Market Ratios

82 82

Price/Earnings (P/E) Ratio 82 Market/Book (M/B) Ratio 83 6 REVIEW QUESTION

83

3.8 A Complete Ratio Analysis 84

Summarizing All Ratios 84 Dupont System of Analysis 85 6 REVIEW QUESTIONS

90

Summary 90 Opener-in-Review 92 Self-Test Problems 92 Warm-Up Exercises 93 Problems 94 Spreadsheet Exercise 110

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Contents

4 Cash Flow and Financial Planning page 113

4.1 Analyzing the Firm’s Cash Flow 115

4.4 Profit Planning: Pro Forma Statement 135

Depreciation 115 Depreciation Methods 116 Developing the Statement of Cash Flows 117

Preceding Year’s Financial Statements 135

Free Cash Flow

122

in practice Focus on Practice: Free Cash Flow at Cisco Systems 123

6 REVIEW QUESTIONS Apple—Investors Want Apple to Take a Bite Out of its Cash Hoard page 114

124

Sales Forecast

135

6 REVIEW QUESTION

135

4.5 Preparing the Pro Forma Income Statement 137

Considering Types of Costs and Expenses 137

4.2 The Financial Planning Process 124

6 REVIEW QUESTIONS

Long-Term (Strategic) Financial Plans 124 Short-Term (Operating) Financial Plans 125

4.6 Preparing the Pro Forma Balance Sheet 139

in practice Focus on Ethics: How Much Is a CEO Worth? 125

6 REVIEW QUESTIONS

127

4.3 Cash Planning: Cash Budgets 127

The Sales Forecast 127 Preparing the Cash Budget 128 Evaluating the Cash Budget 132 Coping with Uncertainty in the Cash Budget 133 Cash Flow within the Month 134 6 REVIEW QUESTIONS

135

6 REVIEW QUESTIONS

139

141

4.7 Evaluation of Pro Forma Statements 141 6 REVIEW QUESTIONS

141

Summary 142 Opener-in-Review 143 Self-Test Problems 144 Warm-Up Exercises 145 Problems 146 Spreadsheet Exercise 157

Contents

5 Time Value of Money page 159

5.1 The Role of Time Value in Finance 161

Future Value versus Present Value 161 Computational Tools 162 Basic Patterns of Cash Flow 163 6 REVIEW QUESTIONS

5.2

164

Single Amounts

164

Future Value of a Single Amount 164 Present Value of a Single Amount 168 Eli Lilly and Company— Riding the Pipeline page 160

6 REVIEW QUESTIONS

5.3

Annuities

170

171

Types of Annuities 171 Finding the Future Value of an Ordinary Annuity 172 Finding the Present Value of an Ordinary Annuity 173 Finding the Future Value of an Annuity Due 175 Finding the Present Value of an Annuity Due 176 Finding the Present Value of a Perpetuity 178 6 REVIEW QUESTIONS

5.4

178

Mixed Streams

178

Future Value of a Mixed Stream 179 Present Value of a Mixed Stream 180 6 REVIEW QUESTION

181

5.5 Compounding Interest More Frequently Than Annually 181

Semiannual Compounding 181 Quarterly Compounding 182

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A General Equation for Compounding More Frequently Than Annually 183 Using Computational Tools for Compounding More Frequently Than Annually 184 Continuous Compounding 184 Nominal and Effective Annual Rates of Interest 185 in practice Focus on Ethics: How Fair Is “Check into Cash”? 187

6 REVIEW QUESTIONS

187

5.6 Special Applications of Time Value 188

Determining Deposits Needed to Accumulate a Future Sum 188 Loan Amortization 189 in practice Focus on Practice: New Century Brings Trouble for Subprime Mortgages 191

Finding Interest or Growth Rates 191 Finding an Unknown Number of Periods 192 6 REVIEW QUESTIONS

194

Summary 194 Opener-in-Review 195 Self-Test Problems 196 Warm-Up Exercises 197 Problems 198 Spreadsheet Exercise 214 Integrative Case 2 Track Software, Inc. 215

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Part 3

Contents

Valuation of Securities

6 Interest Rates and Bond Valuation page 220

219

6.1 Interest Rates and Required Returns 222

Interest Rate Fundamentals 222 in practice Focus on Practice: I-Bonds Adjust for Inflation 225

Term Structure of Interest Rates 226 Risk Premiums: Issuer and Issue Characteristics 229 6 REVIEW QUESTIONS

6.2 The Federal Debt—A Huge Appetite for Money page 221

230

Corporate Bonds

231

Legal Aspects of Corporate Bonds 232 Cost of Bonds to the Issuer 233 General Features of a Bond Issue 233 Bond Yields 234 Bond Prices 234 Bond Ratings 235 in practice Focus on Ethics: Can We Trust the Bond Raters? 236

Common Types of Bonds 236 International Bond Issues 237 6 REVIEW QUESTIONS

238

6.3

Valuation Fundamentals

Key Inputs 239 Basic Valuation Model 240 6 REVIEW QUESTIONS

6.4

241

Bond Valuation

241

Bond Fundamentals 241 Basic Bond Valuation 242 Bond Value Behavior 243 Yield to Maturity (YTM) 247 Semiannual Interest and Bond Values 248 6 REVIEW QUESTIONS

249

Summary 250 Opener-in-Review 251 Self-Test Problems 252 Warm-Up Exercises 252 Problems 254 Spreadsheet Exercise 263

239

Contents

7 Stock Valuation page 264

7.1 Differences between Debt and Equity 266

Voice in Management 266 Claims on Income and Assets 266 Maturity 267 Tax Treatment 267 6 REVIEW QUESTION

267

7.2 Common and Preferred Stock 267 A123 Systems Inc.—Going Green to Find Value page 265

Common Stock 268 Preferred Stock 271 Issuing Common Stock 6 REVIEW QUESTIONS

Other Approaches to Common Stock Valuation 287 in practice Focus on Ethics: Psst—Have You Heard Any Good Quarterly Earnings Forecasts Lately? 288

6 REVIEW QUESTIONS

276

7.3 Common Stock Valuation 277

Market Efficiency 277 The Efficient-Market Hypothesis 278 in practice Focus on Practice: Understanding Human Behavior Helps Us Understand Investor Behavior 279

Basic Common Stock Valuation Equation 279 Free Cash Flow Valuation Model 284

289

7.4 Decision Making and Common Stock Value 290

Changes in Expected Dividends 290 Changes in Risk 291 Combined Effect 291 6 REVIEW QUESTIONS

272

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292

Summary 292 Opener-in-Review 294 Self-Test Problems 294 Warm-Up Exercises 295 Problems 296 Spreadsheet Exercise 303 Integrative Case 3 Encore International 304

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Part 4

Contents

Risk and the Required Rate of Return

8 Risk and Return page 308

8.1 Risk and Return Fundamentals 310

Risk Defined 310 in practice Focus on Ethics: If It Seems Too Good to Be True Then It Probably Is 310

Return Defined 311 6 REVIEW QUESTIONS

8.2

313

Risk of a Single Asset

Risk Assessment 313 Risk Measurement 315 6 REVIEW QUESTIONS

8.3

Diversification 323 Correlation, Diversification, Risk, and Return 326 International Diversification 327 in practice Global Focus: An International Flavor to Risk Reduction 328

6 REVIEW QUESTIONS

Risk Preferences 312 Mutual Funds—Fund’s Returns Not Even Close to Average page 309

307

328

8.4 Risk and Return: The Capital Asset Pricing Model (CAPM) 329 313

Types of Risk

329

The Model: CAPM 330 6 REVIEW QUESTIONS 320

Risk of a Portfolio

321

Portfolio Return and Standard Deviation 321 Correlation 323

339

Summary 339 Opener-in-Review 340 Self-Test Problems 341 Warm-Up Exercises 342 Problems 343 Spreadsheet Exercise 355

Contents

9 The Cost of Capital page 356

Cost of Retained Earnings 367 Cost of New Issues of Common Stock 368

9.1 Overview of the Cost of Capital 358

The Basic Concept 358 in practice Focus on Ethics: The Ethics of Profit 358

Sources of Long-Term Capital 6 REVIEW QUESTIONS

9.2 General Electric—Falling Short of Expectations page 357

359

360

Cost of Long-Term Debt

360

6 REVIEW QUESTIONS

369

9.5 Weighted Average Cost of Capital 369

Calculating Weighted Average Cost of Capital (WACC) 369 in practice Focus on Practice: Uncertain Times Make for an Uncertain Weighted Average Cost of Capital 371

Net Proceeds 360 Before-Tax Cost of Debt 361 After-Tax Cost of Debt 363

Weighting Schemes 372

6 REVIEW QUESTIONS

6 REVIEW QUESTIONS

9.3

364

Cost of Preferred Stock

364

Preferred Stock Dividends 364 Calculating the Cost of Preferred Stock 364 6 REVIEW QUESTION

9.4

365

Cost of Common Stock

Finding the Cost of Common Stock Equity 365

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365

373

Summary 373 Opener-in-Review 374 Self-Test Problems 374 Warm-Up Exercises 375 Problems 376 Spreadsheet Exercise 383 Integrative Case 4 Eco Plastics Company 385

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Part 5

Contents

Long-Term Investment Decisions

10 Capital Budgeting Techniques page 388

10.1 Overview of Capital Budgeting 390

10.4 Internal Rate of Return (IRR) 401

Motives for Capital Expenditure 390 Steps in the Process 390 Basic Terminology 391 Capital Budgeting Techniques 392

Decision Criteria 401 Calculating the IRR 402

6 REVIEW QUESTION

393

10.2 Payback Period

Genco Resources—The Gold Standard for Evaluating Gold Mines page 389

387

in practice Focus on Practice: Limits on Payback Analysis 395

397

10.3 Net Present Value (NPV)

397

Decision Criteria 397 NPV and the Profitability Index 399 NPV and Economic Value Added 400 6 REVIEW QUESTIONS

401

404

10.5 Comparing NPV and IRR Techniques 404

Net Present Value Profiles 404 Conflicting Rankings 406 Which Approach Is Better? 409

393

Decision Criteria 393 Pros and Cons of Payback Analysis 394

6 REVIEW QUESTIONS

6 REVIEW QUESTIONS

in practice Focus on Ethics: Nonfinancial Considerations in Project Selection 411

6 REVIEW QUESTIONS

411

Summary 412 Opener-in-Review 413 Self-Test Problems 414 Warm-Up Exercises 414 Problems 415 Spreadsheet Exercise 425

Contents

11 Capital Budgeting Cash Flows page 426

11.1 Relevant Cash Flows

428

Major Cash Flow Components

428

in practice Focus on Ethics: A Question of Accuracy 428

Expansion versus Replacement Decisions 429 Sunk Costs and Opportunity Costs 429 International Capital Budgeting and Long-Term Investments 430 6 REVIEW QUESTIONS ExxonMobil—Maintaining Its Project Inventory page 427

Interpreting the Term Cash Inflows 439 Interpreting the Term Incremental 441 6 REVIEW QUESTIONS

443

11.4 Finding the Terminal Cash Flow 443

Proceeds from Sale of Assets 443 Taxes on Sale of Assets 443 Change in Net Working Capital 444 6 REVIEW QUESTION

445

431

in practice Global Focus: Changes May Influence Future Investments in China 432

11.2 Finding the Initial Investment 432

Installed Cost of New Asset 433 After-Tax Proceeds from Sale of Old Asset 433 Change in Net Working Capital 436 Calculating the Initial Investment 437 6 REVIEW QUESTIONS

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438

11.3 Finding the Operating Cash Inflows 438

Interpreting the Term After-Tax 438

11.5 Summarizing the Relevant Cash Flows 445 6 REVIEW QUESTION

447

Summary 447 Opener-in-Review 448 Self-Test Problems 449 Warm-Up Exercises 449 Problems 450 Spreadsheet Exercise 461

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Contents

12 Risk and Refinements in Capital Budgeting page 463

12.1 Introduction to Risk in Capital Budgeting 465

Portfolio Effects 478 RADRs in Practice 478

6 REVIEW QUESTION

6 REVIEW QUESTIONS

465

12.2 Behavioral Approaches for Dealing with Risk 466

12.5 Capital Budgeting Refinements 480

Risk and Cash Inflows 466 Scenario Analysis 467 Simulation 468

Comparing Projects with Unequal Lives 480 Recognizing Real Options 483 Capital Rationing 485

in practice Focus on Practice: The Monte Carlo Method: The Forecast Is for Less Uncertainty 470 BP—Worst Case Scenario page 464

480

6 REVIEW QUESTIONS

470

12.3 International Risk Considerations 470 6 REVIEW QUESTION

471

12.4 Risk-Adjusted Discount Rates 472

Determining Risk-Adjusted Discount Rates (RADRS) 472 in practice Focus on Ethics: Ethics and the Cost of Capital 475

Applying RADRs 475

6 REVIEW QUESTIONS

487

Summary 488 Opener-in-Review 489 Self-Test Problems 490 Warm-Up Exercises 490 Problems 492 Spreadsheet Exercise 502 Integrative Case 5 Lasting Impressions Company 503

Contents

Part 6

Long-Term Financial Decisions

13 Leverage and Capital Structure page 506

13.1 Leverage

508

Breakeven Analysis 509 Operating Leverage 513 in practice Focus on Practice: Adobe’s Leverage 515

Financial Leverage 516 Total Leverage 520 in practice Focus on Ethics: Repo 105 522

6 REVIEW QUESTIONS Genzyme Corp.—Trading Equity for Debt page 507

523

13.2 The Firm’s Capital Structure 523

Types of Capital 523 External Assessment of Capital Structure 524 Capital Structure of Non–U.S. Firms 525 Capital Structure Theory 526 Optimal Capital Structure 535 6 REVIEW QUESTIONS

536

13.3 EBIT–EPS Approach to Capital Structure 537

Presenting a Financing Plan Graphically 537

505 Comparing Alternative Capital Structures 539 Considering Risk in EBIT–EPS Analysis 539 Basic Shortcoming of EBIT–EPS Analysis 540 6 REVIEW QUESTION

540

13.4 Choosing the Optimal Capital Structure 540

Linkage 540 Estimating Value 541 Maximizing Value versus Maximizing EPS 543 Some Other Important Considerations 543 6 REVIEW QUESTIONS

544

Summary 544 Opener-in-Review 546 Self-Test Problems 546 Warm-Up Exercises 547 Problems 548 Spreadsheet Exercise 558

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Contents

14 Payout Policy page 559

14.1 The Basics of Payout Policy 561

14.4 Factors Affecting Dividend Policy 574

Elements of Payout Policy 561 Trends in Earnings and Dividends 562 Trends in Dividends and Share Repurchases 563

Legal Constraints 574 Contractual Constraints 576 Growth Prospects 576

in practice Focus on Ethics: Are Buybacks Really a Bargain? 564

6 REVIEW QUESTIONS Best Buy—Payback Time page 560

565

14.2 The Mechanics of Payout Policy 565

Cash Dividend Payment Procedures 565 Share Repurchase Procedures 567 Tax Treatment of Dividends and Repurchases 568 in practice Focus on Practice: Capital Gains and Dividend Tax Treatment Extended to 2010 569

Owner Considerations 576 Market Considerations 576 6 REVIEW QUESTION

14.5 Types of Dividend Policies 577

Constant-Payout-Ratio Dividend Policy 577 Regular Dividend Policy 578 Low-Regular-and-Extra Dividend Policy 579 6 REVIEW QUESTION

Stock Dividends 579 Stock Splits 581

6 REVIEW QUESTIONS

6 REVIEW QUESTIONS

14.3 Relevance of Payout Policy 571

Residual Theory of Dividends 571 The Dividend Irrelevance Theory 572 Arguments for Dividend Relevance 573 6 REVIEW QUESTIONS

574

579

14.6 Other Forms of Dividends 579

Dividend Reinvestment Plans 570 Stock Price Reactions to Corporate Payouts 570 571

577

583

Summary 583 Opener-in-Review 584 Self-Test Problems 585 Warm-Up Exercises 585 Problems 586 Spreadsheet Exercise 593 Integrative Case 6 O’Grady Apparel Company 594

Contents

Part 7

Short-Term Financial Decisions

15 Working Capital and Current Assets Management page 598

597

15.1 Net Working Capital Fundamentals 600

15.4 Accounts Receivable Management 615

Working Capital Management 600 Net Working Capital 601 Trade-Off between Profitability and Risk 601

Credit Selection and Standards 615 Credit Terms 619 Credit Monitoring 622

6 REVIEW QUESTIONS

6 REVIEW QUESTIONS

623

603

15.2 Cash Conversion Cycle

Cytec Industries—Focusing on Working Capital page 599

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603

15.5 Management of Receipts and Disbursements 624

Calculating the Cash Conversion Cycle 604 Funding Requirements of the Cash Conversion Cycle 605 Strategies for Managing the Cash Conversion Cycle 607

Float 624 Speeding Up Collections 625 Slowing Down Payments 625

6 REVIEW QUESTIONS

Cash Concentration 626 Zero-Balance Accounts 627 Investing in Marketable Securities 629

in practice Focus on Ethics: Stretching Accounts Payable—Is It a Good Policy? 626

608

15.3 Inventory Management

608

Differing Viewpoints about Inventory Level 608 Common Techniques for Managing Inventory 609 in practice Focus on Practice: RFID: The Wave of the Future 613

International Inventory Management 614 6 REVIEW QUESTIONS

614

6 REVIEW QUESTIONS

630

Summary 630 Opener-in-Review 632 Self-Test Problems 632 Warm-Up Exercises 633 Problems 634 Spreadsheet Exercise 639

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Contents

16 Current Liabilities Management page 640

16.1 Spontaneous Liabilities

642

Accounts Payable Management 642 Accruals 647 in practice Focus on Ethics: Accruals Management 647

6 REVIEW QUESTIONS

648

16.2 Unsecured Sources of Short-Term Loans 648

Characteristics of Secured Short-Term Loans 657 Use of Accounts Receivable as Collateral 658 Use of Inventory as Collateral 660 6 REVIEW QUESTIONS

662

International Loans 655

Summary 662 Opener-in-Review 663 Self-Test Problems 664 Warm-Up Exercises 664 Problems 665 Spreadsheet Exercise 671

6 REVIEW QUESTIONS

Integrative Case 7 Casa de Diseño 672

Bank Loans 648 Commercial Paper 654 Memorial Sloan-Kettering Cancer Center—Reducing Accounts Payable Expenses page 641

16.3 Secured Sources of Short-Term Loans 657

in practice Focus on Practice: The Ebb and Flow of Commercial Paper 654

656

Contents

Part 8

17 Hybrid and Derivative Securities page 676

Special Topics in Managerial Finance 17.1 Overview of Hybrids and Derivatives 678 6 REVIEW QUESTION

17.2 Leasing

678

678

Lease-versus-Purchase Decision 681 Effects of Leasing on Future Financing 685 Advantages and Disadvantages of Leasing 686 6 REVIEW QUESTIONS

687

17.3 Convertible Securities

687

693

17.4 Stock Purchase Warrants 693

Key Characteristics 693

697

698

Calls and Puts 698 Options Markets 698 Options Trading 699 Role of Call and Put Options in Fund Raising 700 in practice Focus on Ethics: Options Backdating 701

Hedging Foreign-Currency Exposures with Options 701 6 REVIEW QUESTIONS

Types of Convertible Securities 687 General Features of Convertibles 688 Financing with Convertibles 689 Determining the Value of a Convertible Bond 691 6 REVIEW QUESTIONS

Implied Price of an Attached Warrant 694 Values of Warrants 695

17.5 Options

in practice Focus on Practice: Leases to Airlines End on a Sour Note 680

Boeing—”We’ll Buy It, You Fly It” page 677

675

6 REVIEW QUESTIONS

Types of Leases 678 Leasing Arrangements 679

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702

Summary 702 Opener-in-Review 704 Self-Test Problems 705 Warm-Up Exercises 705 Problems 706 Spreadsheet Exercise 712

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Contents

18 Mergers, LBOs, Divestitures, and Business Failure page 714

18.1 Merger Fundamentals

716

in practice Focus on Ethics: Too Big to Fail? 739

Terminology 716 Motives for Merging 718 Types of Mergers 720 6 REVIEW QUESTIONS

Voluntary Settlements 739 6 REVIEW QUESTIONS

721

Leveraged Buyouts (LBOs) 721 Divestitures 722

IMS Health, Inc.—Creating Value by Going Private page 715

723

18.3 Analyzing and Negotiating Mergers 723

Valuing the Target Company 724 Stock Swap Transactions 726 Merger Negotiation Process 731 Holding Companies 733 International Mergers 735 6 REVIEW QUESTIONS

740

721

18.2 LBOs and Divestitures

6 REVIEW QUESTIONS

Major Causes of Business Failure 738

736

in practice Global Focus: International Mergers 737

18.4 Business Failure Fundamentals 737

Types of Business Failure 737

18.5 Reorganization and Liquidation in Bankruptcy

Bankruptcy Legislation 741 Reorganization in Bankruptcy (Chapter 11) 742 Liquidation in Bankruptcy (Chapter 7) 744 6 REVIEW QUESTIONS

744

Summary 745 Opener-in-Review 747 Self-Test Problems 748 Warm-Up Exercises 748 Problems 749 Spreadsheet Exercise 755

741

Contents

19 International Managerial Finance page 757

19.1 The Multinational Company and Its Environment 759

Key Trading Blocs 759 GATT and the WTO 761 Legal Forms of Business Organization 761

6 REVIEW QUESTIONS

765 765

Subsidiary Characterization and Functional Currency 766 Translation of Individual Accounts 766 6 REVIEW QUESTION

19.3 Risk

767

767

Exchange Rate Risks 767 Political Risks 773 6 REVIEW QUESTIONS

774

in practice Focus on Ethics: Chiquita’s Slippery Situation 775

19.4 Long-Term Investment and Financing Decisions 775

Foreign Direct Investment 775 Investment Cash Flows and Decisions 776 Capital Structure 777

Appendix Glossary Index I-1

A-1 G-1

781

19.5 Short-Term Financial Decisions 781

19.2 Financial Statements General Electric—Establishing a Presence in China page 758

in practice Global Focus: Take an Overseas Assignment to Take a Step Up the Corporate Ladder 778

Long-Term Debt 779 Equity Capital 780

Taxes 762 Financial Markets 764 6 REVIEW QUESTIONS

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Cash Management 783 Credit and Inventory Management 786 6 REVIEW QUESTIONS

787

19.6 Mergers and Joint Ventures 787 6 REVIEW QUESTION

788

Summary 788 Opener-in-Review 790 Self-Test Problems 790 Warm-Up Exercises 791 Problems 791 Spreadsheet Exercise 794 Integrative Case 8 Organic Solutions 795

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About the Authors Lawrence J. Gitman is an emeritus professor of finance at San Diego State University. Dr. Gitman has published more than 50 articles in scholarly journals as well as textbooks covering undergraduate- and graduate-level corporate finance, investments, personal finance, and introduction to business. Dr. Gitman is past president of the Academy of Financial Services, the San Diego Chapter of the Financial Executives Institute, the Midwest Finance Association, and the FMA National Honor Society. Dr. Gitman served as Vice-President of Financial Education of the Financial Management Association, as a director of the San Diego MIT Enterprise Forum, and on the CFP® Board of Standards. He received his B.S.I.M. from Purdue University, his M.B.A. from the University of Dayton, and his Ph.D. from the University of Cincinnati. He and his wife have two children and live in La Jolla, California, where he is an avid bicyclist, having twice competed in the coast-to-coast Race Across America.

Chad J. Zutter is an associate professor of finance at the University of Pittsburgh. Dr. Zutter recently won the Jensen Prize for the best paper published in the Journal of Financial Economics and has also won a best paper award from the Journal of Corporate Finance. His research has a practical, applied focus and has been the subject of feature stories in, among other prominent outlets, The Economist and CFO Magazine. His papers have been cited in arguments before the U.S. Supreme Court and in consultation with companies such as Google and Intel. Dr. Zutter has also won teaching awards at Indiana University and the University of Pittsburgh. He received his B.B.A. from the University of Texas at Arlington and his Ph.D. from Indiana University. He and his wife have four children and live in Pittsburgh, Pennsylvania. Prior to his career in academics, Dr. Zutter was a submariner in the U.S. Navy.

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Preface he desire to write Principles of Managerial Finance came from the experience of teaching the introductory managerial finance course. Those who have taught the introductory course many times can appreciate the difficulties that some students have absorbing and applying financial concepts. Students want a book that speaks to them in plain English and a book that ties concepts to reality. These students want more than just description—they also want demonstration of concepts, tools, and techniques. This book is written with the needs of students in mind, and it effectively delivers the resources that students need to succeed in the introductory finance course. Courses and students have changed since the first edition of this book, but the goals of the text have not changed. The conversational tone and wide use of examples set off in the text still characterize Principles of Managerial Finance. Building on those strengths, 13 editions, numerous translations, and well over half a million U.S. users, Principles has evolved based on feedback from both instructors and students, from adopters, nonadopters, and practitioners. In this edition, Chad Zutter of the University of Pittsburgh joins the author team. A recent recipient of the Jensen Prize for the best paper published in the Journal of Financial Economics, Chad brings a fresh perspective to Principles. Larry and Chad have worked together to incorporate contemporary thinking and pedagogy with the classic topics that Gitman users have come to expect.

T

NEW TO THE THIRTEENTH EDITION As we made plans to publish the thirteenth edition, we carefully assessed market feedback about content changes that would better meet the needs of instructors teaching the course. The chapter sequence is similar to the prior edition, but there are some noteworthy changes. The thirteenth edition contains 19 chapters divided into eight parts. Each part is introduced by a brief overview, which is intended to give students an advance sense for the collective value of the chapters included in the part. In Part 1, a new Chapter 2 expands coverage of financial markets and institutions, with particular emphasis on the recent financial crisis and recession. This chapter not only explores the root causes and consequences of the financial crisis, but it also discusses the changing regulatory landscape within which financial institutions and markets function. Part 2 contains three chapters in the same order in which they appeared in the twelfth edition. These chapters focus on basic financial skills such as financial statement analysis, cash flow analysis, and time-value-of-money calculations. Part 3 focuses on bond and stock valuation. We moved these two chapters forward in this edition, just ahead of the risk and return chapter, to provide students with exposure to basic material on bonds and stocks that is easier to grasp than some of the more theoretical concepts in the next part.

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Preface

Part 4 contains the risk and return chapter as well as the chapter on the cost of capital, which we have moved forward to lead into Part 5 on capital budgeting. We also moved up the chapter on the cost of capital so that it follows directly on the heels of the risk and return material. We believe that this makes the subsequent discussion of capital budgeting topics more meaningful because students will already have an idea of where a project “hurdle rate” comes from. Part 5 contains three chapters on various capital budgeting topics. A change from the last edition here is that we present capital budgeting methods before the chapter on capital budgeting cash flows. Parts 6, 7, and 8 contain the same seven chapters in the same order that appeared in the latter part of the twelfth edition. These chapters cover topics such as capital structure, payout policy, working capital management, derivatives, mergers, and international finance. Details about the revisions made to these chapters appear below. Although the text content is sequential, instructors can assign almost any chapter as a self-contained unit, enabling instructors to customize the text to various teaching strategies and course lengths. A number of new topics have been added at appropriate places, and new features appear in each chapter. The Matter of Fact feature provides additional detail and interesting empirical facts that help students understand the practical implications of financial concepts. For students who want to explore particular topics more deeply on their own, the In More Depth feature, available on MyFinanceLab, offers a guide for further study. In addition, as the detailed list shows, the chapteropening vignettes and In Practice boxes have been replaced or heavily revised: For example, three-quarters of the chapter-opening vignettes are new, focusing on companies such as Facebook, Abercrombie & Fitch, and Best Buy that have student appeal, and more than half of the Focus on Ethics boxes are new. Also new to this edition are Opener-in-Review questions, which appear at the end of each chapter. The following chapter-by-chapter list details several of the notable content changes in the thirteenth edition. Chapter 1 The Role of Managerial Finance • Revised opening vignette discusses Facebook’s possible IPO. • New Focus on Practice box discusses professional certifications in finance. • New Matter of Fact feature provides statistics on the number of businesses and the revenues they generate by legal form of organization. • Sections on financial markets and business taxes have been moved to a new, expanded Chapter 2. • Coverage of the difference between cash flow and profit as part of the discussion surrounding the goal of the firm has been revised. • New Focus on Ethics box highlights the ethical issues that Google faced during its expansion to China. • Coverage of agency issues has been substantially revised, and a new Matter of Fact feature provides data on the link between pay and performance for several prominent firms. Chapter 2 The Financial Market Environment • This new chapter focuses on financial markets and institutions as well as the recent financial crisis. • New opening vignette traces JP Morgan’s performance during the crisis.

Preface

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• New section provides coverage of commercial banks, investment banks, and

the shadow banking system. • New Focus on Ethics box is related to the Martha Stewart insider trading

scandal. • New section has been added on causes and consequences of financial crisis. • Coverage of regulatory issues has been updated.

Chapter 3 Financial Statements and Ratio Analysis • New opening vignette has been added (financial results, Abercrombie & Fitch). • New Global Focus box covers International Financial Reporting Standards (IFRS). • New Focus on Ethics box describes ethical issues related to corporate earnings reports. • New table shows values of key ratios for several prominent firms and the related industry averages. Five related Matter of Fact features explain why certain ratio values vary systematically across industries. Chapter 4 Cash Flow and Financial Planning • New opening vignette highlights Apple’s huge cash hoard. • New Matter of Fact box illustrates where Apple’s cash flow comes from. • New Focus on Practice box dissects a recent earnings report by Cisco Systems to explore the firm’s underlying cash generation. • Discussion of alternative cash flow measures has been revised. • New In More Depth feature (on MyFinanceLab) discusses the value of using regression analysis to estimate fixed costs. Chapter 5 Time Value of Money • New In More Depth feature (on MyFinanceLab) shows how the firm Royalty Pharma makes lump-sum payments to acquire royalty streams from other firms. • References to financial tables and interest rate factors have been eliminated. • Coverage of calculations using Excel has been expanded. • New Matter of Fact feature describes a Kansas truck driver’s choice to take a lump-sum payment rather than an annuity due after winning the lottery. • The Focus on Ethics box on subprime loans has been revised. Chapter 6 Interest Rates and Bond Valuation • Opening vignette (U.S. Treasury, public debt) has been updated. • New Matter of Fact feature highlights a 2008 U.S. Treasury auction in which bill returns briefly turned negative. • Discussion of factors that influence interest rates, particularly inflation, has been substantially revised. • New In More Depth feature (on MyFinanceLab) points students to an animation on the Web that illustrates historical yield curve behavior. • Major revisions have been made to coverage of the term structure of interest rates. • Focus on Ethics box on the performance of rating agencies during the financial crisis has been revised.

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Chapter 7 Stock Valuation • New opening vignette has been added about A123 Systems Inc., a company that uses nanotechnology to make more powerful batteries for electric cars. • New In More Depth feature (on MyFinanceLab) discusses the U.S. bankruptcy process. • New Matter of Fact box describes how assets are divided in bankruptcy. • New In More Depth feature (on MyFinanceLab) discusses the hierarchy of the efficient market hypothesis. • New In More Depth feature (on MyFinanceLab) illustrates the derivation of the constant-growth model. • New Matter of Fact box describes how P/E ratios fluctuate over time. Chapter 8 Risk and Return • New opening vignette has been added about a mutual fund that ranked near the bottom and then at the top of all mutual funds in consecutive years. • New Focus on Ethics box features Bernie Madoff. • New numerical examples have data drawn from the real world. • Historical returns on U.S. stocks, bonds, and bills have been updated. • Discussion of investor risk preferences has been substantially revised. • New Matter of Fact feature discusses Nicholas Taleb’s Black Swan. • New Matter of Fact box compares historical returns on large stocks versus small stocks. • New Global Focus box features data on international diversification. Chapter 9 The Cost of Capital • New opening vignette focuses on General Electric. • New Focus on Ethics box deals with Merck’s handling of Vioxx. • New In More Depth feature (on MyFinanceLab) discusses changes in the weighted average cost of capital. • New Matter of Fact box presents a more comprehensive cost of retained earnings. • New Focus on Practice feature focuses on WACC’s susceptibility to the 2008 financial crisis and the 2009 great recession. • New integrative case for Part 4 has been added. Chapter 10 Capital Budgeting Techniques • New opening vignette describes techniques used by Genco Resources to evaluate a proposal to expand its mining operations. • New In More Depth feature (on MyFinanceLab) discusses the Accounting Rate of Return method. • Substantially revised opening section discusses the capital budgeting process. • Coverage of profitability index approach has been expanded. • Coverage of economic value added has been expanded. • New Matter of Fact box provides evidence on the extent to which firms use different capital budgeting methods. Chapter 11 Capital Budgeting Cash Flows • Opening vignette (project costs at ExxonMobil) has been updated. • New Matter of Fact box provides statistics on foreign direct investment in the United States.

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• Global Focus box (foreign direct investment in China) has been updated. • Focus on Ethics box (accuracy of cash flow estimates) has been updated. • Two new Integrative Problems have been added.

Chapter 12 Risk and Refinements in Capital Budgeting • New opening vignette discusses BP oil spill. • New In More Depth feature (on MyFinanceLab) directs students to a Crystal Ball simulation of a mining investment on the Internet. • New Matter of Fact box provides evidence on the frequency with which firms make adjustments to their investment analysis to account for currency risk. • New Focus on Ethics box discusses the implications of the BP oil spill on the firm’s cost of capital. Chapter 13 Leverage and Capital Structure • New opening vignette discuss the value created by Genzyme when it added debt to its capital structure in response to a proxy fight with Carl Icahn. • Substantially revised opening section discusses the nature and risks of leverage. • Revised Focus on Practice box calculates Adobe’s operating leverage. • New Focus on Ethics box discusses Lehman Brothers’ use of off–balance sheet transactions to understate its leverage. • New Matter of Fact box offers data on the use of financial leverage by firms in different countries. • New In More Depth feature (on MyFinanceLab) explains why capital structure does not affect firm value in perfect markets. • Major revisions have been made to the discussion of the pecking order and signaling theories of capital structure. Chapter 14 Payout Policy • New chapter title reflects broader focus on payout policy, including share repurchases as opposed to a narrow focus on dividends. • Revised opening vignette covers Best Buy’s dividend and share repurchase programs. • New opening section discusses long-term trends in earnings, dividends, and repurchases. • New Matter of Fact box describes Procter & Gamble’s long dividend history. • New figure shows relative frequency of firms increasing and decreasing dividends over time. • New examples have real-world data. • Extensive new discussion of share repurchase programs and procedures has been added. • New discussion covers effects of dividend and share repurchase decisions on firm value. • New In More Depth feature (on MyFinanceLab) explains the conditions under which dividend policy has no impact on firm value. • Extensive revisions have been made to discussions of alternative dividend theories and a brief introduction to the new catering theory of dividends has been added.

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Chapter 15 Working Capital and Current Assets Management • New opening vignette focuses on working capital at Cytec Industries. • New figure shows the yearly median working capital values for all U.S.-listed manufacturing companies. • Updated example for calculating the cash conversion cycle uses real data for IBM. • Updated Focus on Practice box discusses Walmart’s use of RFID. • New In More Depth feature (on MyFinanceLab) discusses accounts receivable financing. • New Matter of Fact box cites finding from a survey of CFOs regarding the value they place on working capital management. Chapter 16 Current Liabilities Management • Updated opening vignette covers reducing accounts payable expenses at Memorial Sloan-Kettering. • Revised in-chapter examples use real data for Hewlett-Packard. • Focus on Practice box (commercial paper) has been updated. • New Focus on Ethics box discusses the accounting fraud case against Diebold Inc. • Two new Matter of Fact boxes have been added, one on lending limits and the other on quasi-factoring. • Several In More Depth features (on MyFinanceLab) have been added, including one that discusses floating inventory liens. Chapter 17 Hybrid and Derivative Securities • New opening vignette discusses airlines sale-leaseback transactions. • New Matter of Fact feature provides recent data on the size of the convertibles market. • Major revisions to options coverage include a Matter of Fact box that describes the decline in trading volume during the financial crisis and another one outlining some popular options trading strategies. • Updated Focus on Ethics box discusses the options backdating scandal. Chapter 18 Mergers, LBOs, Divestitures, and Business Failure • New opening vignette on creating value by going private has been added. • New In More Depth (on MyFinanceLab) discusses prioritizing claims in liquidation. • Global Focus box (News Corp acquisitions) has been updated. • New Focus on Ethics box discusses General Motors and the “too big to fail” policy. • New Matter of Fact box provides statistics on the ten largest U.S. bankruptcies. Chapter 19 International Managerial Finance • Opening vignette (GE’s business in China) has been updated. • Two new Matter of Fact boxes have been added, one on diversifying operations and the other on adjusting discount rates. • Global Focus box (overseas assignments) has been updated. • New Focus on Ethics box discusses Chiquita’s policy of paying protection money in Colombia.

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THE THIRTEENTH EDITION Like the previous editions, the thirteenth edition incorporates a proven learning system, which integrates pedagogy with concepts and practical applications. It concentrates on the knowledge that is needed to make keen financial decisions in an increasingly competitive business environment. The strong pedagogy and generous use of examples—including personal finance examples—make the text an easily accessible resource for in-class learning or out-of-class learning, such as online courses and self-study programs.

ORGANIZATION The text’s organization conceptually links the firm’s actions and its value, as determined in the financial market. Each major decision area is presented in terms of both risk and return factors and their potential impact on owners’ wealth. A Focus on Value element at the end of each chapter helps reinforce the student’s understanding of the link between the financial manager’s actions and the firm’s share value. In organizing each chapter, we have adhered to a managerial decisionmaking perspective, relating decisions to the firm’s overall goal of wealth maximization. Once a particular concept has been developed, its application is illustrated by an example—a hallmark feature of this book. These examples demonstrate, and solidify in the student’s thought, financial decision-making considerations and their consequences.

INTERNATIONAL CONSIDERATIONS We live in a world where international considerations cannot be divorced from the study of business in general and finance in particular. As in prior editions, discussions of international dimensions of chapter topics are integrated throughout the book. International material is integrated into learning goals and end-of-chapter materials. In addition, for those who want to spend more time addressing the topic, a separate chapter on international managerial finance concludes the book.

PERSONAL FINANCE LINKAGES The thirteenth edition contains several features designed to help students see the value of applying financial principles and techniques in their personal lives. At the start of each chapter, the feature titled Why This Chapter Matters to You helps motivate student interest by discussing how the topic of the chapter relates to the concerns of other major business disciplines and to personal finance. Within the chapter, Personal Finance Examples explicitly link the concepts, tools, and techniques of each chapter to personal finance applications. Throughout the homework material, the book provides numerous personal finance problems. The purpose of these personal finance materials is to demonstrate to students the usefulness of managerial finance knowledge in both business and personal financial dealings.

ETHICAL ISSUES The need for ethics in business remains as important as ever. Students need to understand the ethical issues that financial managers face as they attempt to maximize

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shareholder value and to solve business problems. Thus, every chapter includes an In Practice box that focuses on current ethical issues.

HOMEWORK OPPORTUNITIES Of course, practice is essential for students’ learning of managerial finance concepts, tools, and techniques. To meet that need, the book offers a rich and varied menu of homework assignments: short, numerical Warm-Up Exercises; a comprehensive set of Problems, including more than one problem for each important concept or technique and personal finance problems; an Ethics Problem for each chapter; a Spreadsheet Exercise; and, at the end of each part of the book, an Integrative Case. In addition, the end-of-chapter problems are available in algorithmic form in . These materials (see pages xi through xii for detailed descriptions) offer students solid learning opportunities, and they offer instructors opportunities to expand and enrich the classroom environment.

MyFinanceLab This fully integrated online homework system gives students the hands-on practice and tutorial help they need to learn finance efficiently. There are ample opportunities for online practice and assessment that is automatically graded in MyFinanceLab (www.myfinancelab.com). Chapter Cases with automatically graded assessment are also provided in MyFinanceLab. These cases have students apply the concepts they have learned to a more complex and realistic situation. These cases help strengthen practical application of financial tools and techniques. MyFinanceLab also has Group Exercises where students can work together in the context of an ongoing company. Each group creates a company and follows it through the various managerial finance topics and business activities presented in the textbook. MyFinanceLab provides Critical Thinking Problems, which require students to apply the various finance concepts and managerial techniques presented in the textbook. These are rigorous problems that are designed to test a student’s ability to understand the financial management situation, apply the necessary managerial finance concepts, and find the value-maximizing solution. An online glossary, digital flashcards, financial calculator tutorials, videos, Spreadsheet Use examples from the text in Excel, and numerous other premium resources are available in MyFinanceLab. From classroom to boardroom, the thirteenth edition of Principles of Managerial Finance can help users get to where they want to be. We believe that it is the best edition yet—more relevant, more accurate, and more effective than ever. We hope you agree that Principles of Managerial Finance, Thirteenth Edition, is the most effective introductory managerial finance text for your students. Lawrence J. Gitman La Jolla, California Chad J. Zutter Pittsburgh, Pennsylvania

Supplements to the Thirteenth Edition The Principles of Managerial Finance Teaching and Learning System includes a variety of useful supplements for teachers and for students.

TEACHING TOOLS FOR INSTRUCTORS The key teaching tools available to instructors are the Instructor’s Manual, testing materials, and PowerPoint Lecture Presentations. Instructor’s Manual Revised by Thomas Krueger, Texas A&M University– Kingsville and accuracy-checked by Gordon Stringer, University of Colorado, Colorado Springs. This comprehensive resource pulls together the teaching tools so that instructors can use the textbook easily and effectively in the classroom. Each chapter provides an overview of key topics and detailed answers and solutions to all review questions, Opener-in-Review questions, Warm-Up Exercises, end-of-chapter problems, and chapter cases, plus suggested answers to all critical thinking questions in chapter boxes, Ethics Problems, and Group Exercises. At the end of the manual are practice quizzes and solutions. The complete Instructor’s Manual, including Spreadsheet Exercises, is available online at the Instructor’s Resource Center (www.pearsonhighered.com/irc). Test Item File Revised by Shannon Donovan, Bridgewater State University. Thoroughly revised to accommodate changes in the text, the Test Item File consists of a mix of true/false, multiple-choice, and essay questions. Each test question includes identifiers for type of question, skill tested by learning goal, and key topic tested plus, where appropriate, the formula(s) or equation(s) used in deriving the answer. The Test Item File is also available in Test Generator Software (TestGen) for either Windows or Macintosh. The Test Item File and TestGen are available online at the Instructor’s Resource Center (www.pearsonhighered.com/irc). PowerPoint Lecture Presentation Revised by Thomas Boulton, Miami University. This presentation combines lecture notes with all of the art from the textbook. The PowerPoint Lecture Presentation is available online at the Instructor’s Resource Center (www.pearsonhighered.com/irc).

LEARNING TOOLS FOR STUDENTS Beyond the book itself, students have access to valuable resources, such as MyFinanceLab and the Study Guide, that if taken advantage of can help ensure their success. MyFinanceLab MyFinanceLab opens the door to a powerful Web-based diagnostic testing and tutorial system designed specifically for the Gitman/Zutter, Principles of Managerial Finance textbooks. With MyFinanceLab, instructors can create, edit, and assign online homework and test and track all student work in the online gradebook. MyFinanceLab allows students to take practice tests correlated to the textbook and receive a customized study plan based on the test results.

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Supplements to the Thirteenth Edition

Most end-of-chapter problems are available in MyFinanceLab, and because the problems have algorithmically generated values, no student will have the same homework as another; there is an unlimited opportunity for practice and testing. Students get the help they need, when they need it, from the robust tutorial options, including “View an Example” and “Help Me Solve This,” which breaks the problem into its steps and links to the relevant textbook page. This fully integrated online homework system gives students the hands-on practice and tutorial help they need to learn finance efficiently. There are ample opportunities for online practice and assessment that is automatically graded in MyFinanceLab (www.myfinancelab.com). Advanced reporting features in MyFinanceLab also allow you to easily report on AACSB accreditation and assessment in just a few clicks. Chapter Cases with automatically graded assessment are also provided in MyFinanceLab. These cases have students apply the concepts they have learned to a more complex and realistic situation. These cases help strengthen practical application of financial tools and techniques. MyFinanceLab also has Group Exercises where students can work together in the context of an ongoing company. Each group creates a company and follows it through the various managerial finance topics and business activities presented in the textbook. MyFinanceLab provides Critical Thinking Problems, which require students to apply the various finance concepts and managerial techniques presented in the textbook. These are rigorous problems that are designed to test a student’s ability to understand the financial management situation, apply the necessary managerial finance concepts, and find the value-maximizing solution. An online glossary, digital flashcards, financial calculator tutorials, videos, Spreadsheet Use examples from the text in Excel, and numerous other premium resources are available in MyFinanceLab. Students can use MyFinanceLab with no instructor intervention. However, to take advantage of the full capabilities of MyFinanceLab, including assigning homework and tracking student progress in the automated gradebook, instructors will want to set up their class. To view a demo of MyFinanceLab or to request instructor access go to www.myfinancelab.com. Study Guide Revised by Shannon Donovan, Bridgewater State University. The Study Guide is an integral component of the Principles of Managerial Finance Teaching and Learning System. It offers many tools for studying finance. Each chapter contains the following features: chapter summary enumerated by learning goals; topical chapter outline, also broken down by learning goals for quick review; sample problem solutions; study tips and a full sample exam with the answers at the end of the chapter. A financial dictionary of key terms is located at the end of the Study Guide, along with an appendix with tips on using financial calculators.

Acknowledgments TO OUR COLLEAGUES, FRIENDS, AND FAMILY Prentice Hall sought the advice of a great many excellent reviewers, all of whom influenced the revisions of this book. The following individuals provided extremely thoughtful and useful comments for the preparation of the thirteenth edition: Johnny C. Chan, Western Kentucky University Kent Cofoid, Seminole Community College Shannon Donovan, Bridgewater State University Suk Hun Lee, Loyola University Chicago Hao Lin, California State University–Sacramento Larry Lynch, Roanoke College Alvin Nishimoto, Hawaii Pacific University William Sawatski, Southwestern College Steven R. Scheff, Florida Gulf Coast University Michael Schellenger, University of Wisconsin, Oshkosh Gordon M. Stringer, University of Colorado–Colorado Springs Barry Uze, University of Southwestern Louisiana Sam Veraldi, Duke University John Zietlow, Malone University

Our special thanks go to the following individuals who analyzed the manuscript in previous editions: Saul W. Adelman M. Fall Ainina Gary A. Anderson Ronald F. Anderson James M. Andre Gene L. Andrusco Antonio Apap David A. Arbeit Allen Arkins Saul H. Auslander Peter W. Bacon Richard E. Ball Thomas Bankston Alexander Barges Charles Barngrover Michael Becker Omar Benkato Scott Besley Douglas S. Bible Charles W. Blackwell Russell L. Block Calvin M. Boardman Paul Bolster Robert J. Bondi

Jeffrey A. Born Jerry D. Boswell Denis O. Boudreaux Kenneth J. Boudreaux Wayne Boyet Ron Braswell Christopher Brown William Brunsen Samuel B. Bulmash Francis E. Canda Omer Carey Patrick A. Casabona Robert Chatfield K. C. Chen Roger G. Clarke Terrence M. Clauretie Mark Cockalingam Boyd D. Collier Thomas Cook Maurice P. Corrigan Mike Cudd Donnie L. Daniel Prabir Datta Joel J. Dauten

Lee E. Davis Irv DeGraw Richard F. DeMong Peter A. DeVito James P. D’Mello R. Gordon Dippel Carleton Donchess Thomas W. Donohue Vincent R. Driscoll Betty A. Driver Lorna Dotts David R. Durst Dwayne O. Eberhardt Ronald L. Ehresman Ted Ellis F. Barney English Greg Filbeck Ross A. Flaherty Rich Fortin Timothy J. Gallagher George W. Gallinger Sharon Garrison Gerald D. Gay Deborah Giarusso

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Acknowledgments

R. H. Gilmer Anthony J. Giovino Michael Giuliano Philip W. Glasgo Jeffrey W. Glazer Joel Gold Ron B. Goldfarb Dennis W. Goodwin David A. Gordon J. Charles Granicz C. Ramon Griffin Reynolds Griffith Arthur Guarino Lewell F. Gunter Melvin W. Harju John E. Harper Phil Harrington George F. Harris George T. Harris John D. Harris Mary Hartman R. Stevenson Hawkey Roger G. Hehman Harvey Heinowitz Glenn Henderson Russell H. Hereth Kathleen T. Hevert J. Lawrence Hexter Douglas A. Hibbert Roger P. Hill Linda C. Hittle James Hoban Hugh A. Hobson Keith Howe Kenneth M. Huggins Jerry G. Hunt Mahmood Islam James F. Jackson Stanley Jacobs Dale W. Janowsky Jeannette R. Jesinger Nalina Jeypalan Timothy E. Johnson Roger Juchau Ashok K. Kapoor Daniel J. Kaufman Jr. Joseph K. Kiely Terrance E. Kingston Raj K. Kohli Thomas M. Krueger Lawrence Kryzanowski Harry R. Kuniansky Richard E. La Near William R. Lane

James Larsen Rick LeCompte B. E. Lee Scott Lee Michael A. Lenarcic A. Joseph Lerro Thomas J. Liesz Alan Lines Christopher K. Ma James C. Ma Dilip B. Madan Judy Maese James Mallet Inayat Mangla Bala Maniam Timothy A. Manuel Brian Maris Daniel S. Marrone William H. Marsh John F. Marshall Linda J. Martin Stanley A. Martin Charles E. Maxwell Timothy Hoyt McCaughey Lee McClain Jay Meiselman Vincent A. Mercurio Joseph Messina John B. Mitchell Daniel F. Mohan Charles Mohundro Gene P. Morris Edward A. Moses Tarun K. Mukherjee William T. Murphy Randy Myers Lance Nail Donald A. Nast Vivian F. Nazar G. Newbould Charles Ngassam Gary Noreiko Dennis T. Officer Kathleen J. Oldfather Kathleen F. Oppenheimer Richard M. Osborne Jerome S. Osteryoung Prasad Padmanabahn Roger R. Palmer Don B. Panton John Park Ronda S. Paul Bruce C. Payne Gerald W. Perritt

Gladys E. Perry Stanley Piascik Gregory Pierce Mary L. Piotrowski D. Anthony Plath Jerry B. Poe Gerald A. Pogue Suzanne Polley Ronald S. Pretekin Fran Quinn Rich Ravichandran David Rayone Walter J. Reinhart Jack H. Reubens Benedicte Reyes William B. Riley Jr. Ron Rizzuto Gayle A. Russell Patricia A. Ryan Murray Sabrin Kanwal S. Sachedeva R. Daniel Sadlier Hadi Salavitabar Gary Sanger Mukunthan Santhanakrishnan William L. Sartoris Michael Schinski Tom Schmidt Carl J. Schwendiman Carl Schweser Jim Scott John W. Settle Richard A. Shick A. M. Sibley Sandeep Singh Surendra S. Singhvi Stacy Sirmans Barry D. Smith Gerald Smolen Ira Smolowitz Jean Snavely Joseph V. Stanford John A. Stocker Lester B. Strickler Elizabeth Strock Donald H. Stuhlman Sankar Sundarrajan Philip R. Swensen S. Tabriztchi John C. Talbott Gary Tallman Harry Tamule Richard W. Taylor

Acknowledgments

Rolf K. Tedefalk Richard Teweles Kenneth J. Thygerson Robert D. Tollen Emery A. Trahan Pieter A. Vandenberg Nikhil P. Varaiya Oscar Varela Kenneth J. Venuto James A. Verbrugge Ronald P. Volpe John M. Wachowicz Jr.

Faye (Hefei) Wang William H. Weber III Herbert Weinraub Jonathan B. Welch Grant J. Wells Larry R. White Peter Wichert C. Don Wiggins Howard A. Williams Richard E. Williams Glenn A. Wilt Jr. Bernard J. Winger

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Tony R. Wingler I. R. Woods John C. Woods Robert J. Wright Richard H. Yanow Seung J. Yoon Charles W. Young Philip J. Young Joe W. Zeman J. Kenton Zumwalt Tom Zwirlein

A special thanks goes to Thomas J. Boulton of Miami University for his work on the Focus on Ethics boxes and to Alan Wolk of the University of Georgia for accuracy checking the quantitative content in the textbook. We are pleased by and proud of all their efforts. No textbook would be complete, let alone usable, if not for the accompanying instructor and student supplements. We are grateful to the following individuals for their work creating, revising, and accuracy checking all of the valuable instructor and student resources that support the use of Principles: Thomas Krueger of Texas A&M University–Kingsville for updating the Instructor’s Manual, Gordon Stringer of University of Colorado–Colorado Springs for accuracy checking the Instructor’s Manual, Thomas J. Boulton of Miami University for revising the PowerPoint Lecture Presentation, and Shannon Donovan of Bridgewater State University for revising the Test Item File and the Study Guide. A hearty round of applause also goes to the publishing team assembled by Prentice Hall—including Donna Battista, Tessa O’Brien, Kerri McQueen, Melissa Pellerano, Nancy Freihofer, Alison Eusden, Nicole Sackin, Miguel Leonarte, and others who worked on the book—for the inspiration and the perspiration that define teamwork. Also, special thanks to the formidable Prentice Hall sales force in finance, whose ongoing efforts keep the business fun! Finally, and most important, many thanks to our families for patiently providing support, understanding, and good humor throughout the revision process. To them we will be forever grateful. Lawrence J. Gitman La Jolla, California Chad J. Zutter Pittsburgh, Pennsylvania

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To the Student ecause you have a good many options for getting your assigned reading materials we appreciate your choosing this textbook as the best means for learning in your managerial finance course. You should not be disappointed. In writing this edition, we have been mindful of students and careful to maintain a student focus. The learning system in this book has been used by many of your predecessors in the course and has been proven effective. It integrates various learning tools with the concepts, tools, techniques, and practical applications you will need to learn about managerial finance. We have worked hard to present in a clear and interesting way the information you will need. This book is loaded with features designed to motivate your study of finance and to help you learn the course material. Go to pages vii–xii (“Our Proven Teaching and Learning System”) for an overview and walkthrough of those features. Notice that the book includes Personal Finance Examples (and related end-of-chapter problems) that show how to apply managerial finance concepts and tools to your personal financial life. About some of the specific features: First, pay attention to the learning goals, which will help you focus on what material you need to learn, where you can find it in the chapter, and whether you’ve mastered it by the end of the chapter. Second, avoid the temptation to rush past the Review Questions at the end of each major text section. Pausing briefly to test your understanding of the section content will help you cement your understanding. Give yourself an honest assessment. If some details are fuzzy, go back (even briefly) and review anything that still seems unclear. Third, look for (or make) opportunities to talk with classmates or friends about what you are reading and learning in the course. Talking about the concepts and techniques of finance demonstrates how much you’ve learned, uncovers things you haven’t yet understood fully, and gives you valuable practice for class and (eventually) the business world. While you’re talking, don’t neglect to discuss the issues raised in the Focus on Ethics boxes, which look at some of the opportunities to do right (or not) that business people face. MyFinanceLab opens the door to a powerful Web-based diagnostic testing and tutorial system designed for this text. MyFinanceLab allows you to take practice exams correlated to the textbook and receive a customized study plan based on your results. The assignment Problems in MyFinanceLab, based on the even-numbered end-of-chapter Problems in the book, have algorithmically generated values. Thus, the numbers in your homework will differ from those of your classmates, and there is an unlimited opportunity for practice and testing. You can get the help you need, when you need it, from the robust tutorial options, including “View an Example” and “Help Me Solve This,” which breaks the problem into steps and links to the relevant textbook page.

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To the Student

Given today’s rapidly changing technology, who knows what might be available next? We are striving to keep pace with your needs and interests, and would like to hear your ideas for improving the teaching and learning of finance. We wish you all the best in this course and in your academic and professional careers. Lawrence J. Gitman La Jolla, California Chad J. Zutter Pittsburgh, Pennsylvania

Part

1

Introduction to Managerial Finance

Chapters in This Part

1 2

The Role of Managerial Finance The Financial Market Environment INTEGRATIVE CASE 1 Merit Enterprise Corp.

art 1 of Principles of Managerial Finance discusses the role that financial managers play in businesses and the financial market environment in which firms operate. We argue that the goal of managers should be to maximize the value of the firm and by doing so maximize the wealth of its owners. Financial managers act on behalf of the firm’s owners by making operating and investment decisions whose benefits exceed their costs. These decisions create wealth for shareholders. Maximizing shareholder wealth is important because firms operate in a highly competitive financial market environment that offers shareholders many alternatives for investing their funds. To raise the financial resources necessary to fund the firm’s ongoing operations and future investment opportunities, managers have to deliver value to the firm’s investors. Without smart financial managers and access to financial markets, firms are unlikely to survive, let alone achieve the long-term goal of maximizing the value of the firm.

P

1

1

The Role of Managerial Finance

Learning Goals

Why This Chapter Matters to You

LG 1 Define finance and the

In your professional life

managerial finance function.

LG 2 Describe the legal forms of

business organization.

LG 3 Describe the goal of the firm, and

explain why maximizing the value of the firm is an appropriate goal for a business.

LG 4 Describe how the managerial

finance function is related to economics and accounting.

LG 5 Identify the primary activities of

the financial manager.

LG 6 Describe the nature of the

principal–agent relationship between the owners and managers of a corporation, and explain how various corporate governance mechanisms attempt to manage agency problems.

ACCOUNTING You need to understand the relationships between the accounting and finance functions within the firm; how decision makers rely on the financial statements you prepare; why maximizing a firm’s value is not the same as maximizing its profits; and the ethical duty that you have when reporting financial results to investors and other stakeholders. INFORMATION SYSTEMS You need to understand why financial information is important to managers in all functional areas; the documentation that firms must produce to comply with various regulations; and how manipulating information for personal gain can get managers into serious trouble. MANAGEMENT You need to understand the various legal forms of a business organization; how to communicate the goal of the firm to employees and other stakeholders; the advantages and disadvantages of the agency relationship between a firm’s managers and its owners; and how compensation systems can align or misalign the interests of managers and investors. MARKETING You need to understand why increasing a firm’s revenues or market share is not always a good thing; how financial managers evaluate aspects of customer relations such as cash and credit management policies; and why a firm’s brands are an important part of its value to investors. OPERATIONS You need to understand the financial benefits of increasing a firm’s production efficiency; why maximizing profit by cutting costs may not increase the firm’s value; and how managers act on behalf of investors when operating a corporation. Many of the principles of managerial finance also apply to your personal life. Learning a few simple financial principles can help you manage your own money more effectively.

In your personal life

2

Facebook In No Hurry to Go Public

F

acebook founder and chief executive officer Mark Zuckerberg is in no hurry to go public, even

though he concedes that it is an inevitable step in the evolution of his firm. The Facebook CEO is on record saying that “we’re going to go public eventually, because that’s the contract that we have with our investors and our employees. . . . [but] we are definitely in no rush.” Nearly all public firms were at one time privately held by relatively few shareholders, but at some point the firms’ managers decided to go public. The decision to go public is one of the most important decisions managers can make. Private firms are typically held by fewer shareholders and are subject to less regulation than are public firms. So why do firms go public at all? Often it is to provide an exit strategy for its private investors, gain access to investment capital, establish a market price for the firm’s shares, gain public exposure, or all of the above. Going public helps firms grow, but that and other benefits of public ownership must be weighed against the costs of going public. Although taking Facebook public would likely make Zuckerberg one of the richest persons in the world under the age of 30, it would also mean that his firm would become subject to the influences of outside investors and government regulators. A public firm’s managers work for and are responsible to the firm’s investors, and government regulations require firms to provide investors with frequent reports disclosing material information about the firm’s performance. The regulatory demands placed on managers of public firms can sometimes distract managers from important aspects of running their businesses. This chapter will highlight the tradeoffs faced by financial managers as they make decisions intended to maximize the value of their firms.

3

4

PART 1

LG 1

LG 2

Introduction to Managerial Finance

1.1 Finance and Business The field of finance is broad and dynamic. Finance influences everything that firms do, from hiring personnel to building factories to launching new advertising campaigns. Because there are important financial dimensions to almost any aspect of business, there are many financially oriented career opportunities for those who understand the basic principles of finance described in this textbook. Even if you do not see yourself pursuing a career in finance, you’ll find that an understanding of a few key ideas in finance will help make you a smarter consumer and a wiser investor with your own money.

WHAT IS FINANCE? finance The science and art of managing money.

Finance can be defined as the science and art of managing money. At the personal level, finance is concerned with individuals’ decisions about how much of their earnings they spend, how much they save, and how they invest their savings. In a business context, finance involves the same types of decisions: how firms raise money from investors, how firms invest money in an attempt to earn a profit, and how they decide whether to reinvest profits in the business or distribute them back to investors. The keys to good financial decisions are much the same for businesses and individuals, which is why most students will benefit from an understanding of finance regardless of the career path they plan to follow. Learning the techniques of good financial analysis will not only help you make better financial decisions as a consumer, but it will also help you understand the financial consequences of the important business decisions you will face no matter what career path you follow.

CAREER OPPORTUNITIES IN FINANCE Careers in finance typically fall into one of two broad categories: (1) financial services and (2) managerial finance. Workers in both areas rely on a common analytical “tool kit,” but the types of problems to which that tool kit is applied vary a great deal from one career path to the other. financial services

Financial Services

The area of finance concerned with the design and delivery of advice and financial products to individuals, businesses, and governments.

Financial services is the area of finance concerned with the design and delivery of advice and financial products to individuals, businesses, and governments. It involves a variety of interesting career opportunities within the areas of banking, personal financial planning, investments, real estate, and insurance. Managerial Finance

managerial finance Concerns the duties of the financial manager in a business.

Managerial finance is concerned with the duties of the financial manager working in a business. Financial managers administer the financial affairs of all types of businesses—private and public, large and small, profit seeking and not for profit. They perform such varied tasks as developing a financial plan or budget, extending credit to customers, evaluating proposed large expenditures, and raising money to fund the firm’s operations. In recent years, a number of factors have increased the importance and complexity of the financial manager’s duties. These factors include the recent global financial crisis and subsequent responses

CHAPTER 1

financial manager Actively manages the financial affairs of all types of businesses, whether private or public, large or small, profit seeking or not for profit.

The Role of Managerial Finance

5

by regulators, increased competition, and technological change. For example, globalization has led U.S. corporations to increase their transactions in other countries, and foreign corporations have done likewise in the United States. These changes increase demand for financial experts who can manage cash flows in different currencies and protect against the risks that arise from international transactions. These changes increase the finance function’s complexity, but they also create opportunities for a more rewarding career. The increasing complexity of the financial manager’s duties has increased the popularity of a variety of professional certification programs outlined in the Focus on Practice box below. Financial managers today actively develop and implement corporate strategies aimed at helping the firm grow and improving its competitive position. As a result, many corporate presidents and chief executive officers (CEOs) rose to the top of their organizations by first demonstrating excellence in the finance function.

LEGAL FORMS OF BUSINESS ORGANIZATION One of the most basic decisions that all businesses confront is how to choose a legal form of organization. This decision has very important financial implications because how a business is organized legally influences the risks that the

focus on PRACTICE Professional Certifications in Finance in practice To be successful in

finance and just about any other field, you need to continue your education beyond your undergraduate degree. For some people that means getting an MBA, but there are many other ways to advance your education and enhance your credentials without getting a graduate degree. In finance, there are a variety of professional certification programs that are widely recognized in the field. Chartered Financial Analyst (CFA)—Offered by the CFA Institute, the CFA program is a graduate-level course of study focused primarily on the investments side of finance. To earn the CFA Charter, students must pass a series of three exams, usually over a 3-year period, and have 48 months of professional experience. Although this program appeals primarily to those who work in the investments field, the skills developed in the CFA program are useful in a variety of corporate finance jobs as well.

Certified Treasury Professional (CTP)—The CTP program requires students to pass a single exam that is focused on the knowledge and skills needed for those working in a corporate treasury department. The program emphasizes topics such as liquidity and working capital management, payment transfer systems, capital structure, managing relationships with financial service providers, and monitoring and controlling financial risks. Certified Financial Planner (CFP)— To obtain CFP status, students must pass a 10-hour exam covering a wide range of topics related to personal financial planning. The CFP program also requires 3 years of full-time relevant experience. The program focuses primarily on skills relevant for advising individuals in developing their personal financial plans. American Academy of Financial Management (AAFM)—The AAFM administers a host of certification programs for financial professionals

in a wide range of fields. Their certifications include the Chartered Portfolio Manager, Chartered Asset Manager, Certified Risk Analyst, Certified Cost Accountant, Certified Credit Analyst, and many other programs. See the AAFM website for complete details on all of the AAFM educational programs. Professional Certifications in Accounting—Most professionals in the field of managerial finance need to know a great deal about accounting to succeed in their jobs. Professional certifications in accounting include the Certified Public Accountant (CPA), Certified Management Accountant (CMA), Certified Internal Auditor (CIA), and many other programs. 3 Why do employers value having employees with professional certifications?

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firm’s owners must bear, how the firm can raise money, and how the firm’s profits will be taxed. The three most common legal forms of business organization are the sole proprietorship, the partnership, and the corporation. More businesses are organized as sole proprietorships than any other legal form. However, the largest businesses are almost always organized as corporations. Even so, each type of organization has its advantages and disadvantages. Sole Proprietorships sole proprietorship A business owned by one person and operated for his or her own profit.

unlimited liability The condition of a sole proprietorship (or general partnership), giving creditors the right to make claims against the owner’s personal assets to recover debts owed by the business.

partnership A business owned by two or more people and operated for profit.

articles of partnership The written contract used to formally establish a business partnership.

A sole proprietorship is a business owned by one person who operates it for his or her own profit. About 73 percent of all businesses are sole proprietorships. The typical sole proprietorship is small, such as a bike shop, personal trainer, or plumber. The majority of sole proprietorships operate in the wholesale, retail, service, and construction industries. Typically, the owner (proprietor), along with a few employees, operates the proprietorship. The proprietor raises capital from personal resources or by borrowing, and he or she is responsible for all business decisions. As a result, this form of organization appeals to entrepreneurs who enjoy working independently. A major drawback to the sole proprietorship is unlimited liability, which means that liabilities of the business are the entrepreneur’s responsibility, and creditors can make claims against the entrepreneur’s personal assets if the business fails to pay its debts. The key strengths and weaknesses of sole proprietorships are summarized in Table 1.1. Partnerships

A partnership consists of two or more owners doing business together for profit. Partnerships account for about 7 percent of all businesses, and they are typically larger than sole proprietorships. Partnerships are common in the finance, insurance, and real estate industries. Public accounting and law partnerships often have large numbers of partners. Most partnerships are established by a written contract known as articles of partnership. In a general (or regular) partnership, all partners have unlimited liability, and each partner is legally liable for all of the debts of the partnership. Table 1.1 summarizes the strengths and weaknesses of partnerships.

Matter of fact BizStats.com Total Receipts by Type of U.S. Firm

A

lthough there are vastly more sole proprietorships than there are partnerships and corporations combined, they generate the lowest level of receipts. In total, sole proprietorships generated more than $969 billion in receipts, but this number hardly compares to the more than $17 trillion in receipts generated by corporations. BizStats.com Total Receipts by Type of U.S. Firm Number of firms (millions) Percentage of all firms Total receipts ($ billions) Percentage of all receipts

Sole proprietorships

Partnerships

Corporations

17.6 73% 969 5%

1.8 7% 1,142 6%

4.8 20% 17,324 89%

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TA B L E 1 . 1

Strengths

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7

Strengths and Weaknesses of the Common Legal Forms of Business Organization Sole proprietorship

Partnership

Corporation

• Owner receives all profits (and sustains all losses)

• Can raise more funds than sole proprietorships

• Low organizational costs

• Borrowing power enhanced by more owners

• Owners have limited liability, which guarantees that they cannot lose more than they invested

• More available brain power and managerial skill

• Can achieve large size via sale of ownership (stock)

• Income included and taxed on partner’s personal tax return

• Ownership (stock) is readily transferable

• Income included and taxed on proprietor’s personal tax return • Independence • Secrecy • Ease of dissolution

• Long life of firm • Can hire professional managers • Has better access to financing

Weaknesses

• Owner has unlimited liability— total wealth can be taken to satisfy debts

• Owners have unlimited liability and may have to cover debts of other partners

• Limited fund-raising power tends to inhibit growth

• Partnership is dissolved when a partner dies

• Taxes generally higher because corporate income is taxed, and dividends paid to owners are also taxed at a maximum 15% rate

• Proprietor must be jack-of-alltrades

• Difficult to liquidate or transfer partnership

• More expensive to organize than other business forms

• Difficult to give employees longrun career opportunities

• Subject to greater government regulation

• Lacks continuity when proprietor dies

• Lacks secrecy because regulations require firms to disclose financial results

Corporations corporation

A corporation is an entity created by law. A corporation has the legal powers of an individual in that it can sue and be sued, make and be party to contracts, and stockholders acquire property in its own name. Although only about 20 percent of all U.S. The owners of a corporation, businesses are incorporated, the largest businesses nearly always are; corporawhose ownership, or equity, tions account for nearly 90 percent of total business revenues. Although corporatakes the form of either tions engage in all types of businesses, manufacturing firms account for the common stock or preferred largest portion of corporate business receipts and net profits. Table 1.1 lists the stock. key strengths and weaknesses of corporations. limited liability The owners of a corporation are its stockholders, whose ownership, or A legal provision that limits equity, takes the form of either common stock or preferred stock. Unlike the stockholders’ liability for a owners of sole proprietorships or partnerships, stockholders of a corporation corporation’s debt to the amount they initially invested in enjoy limited liability, meaning that they are not personally liable for the firm’s the firm by purchasing stock. debts. Their losses are limited to the amount they invested in the firm when they purchased shares of stock. In Chapter 7 you will learn more about common and common stock The purest and most basic form preferred stock, but for now it is enough to say that common stock is the purest of corporate ownership. and most basic form of corporate ownership. Stockholders expect to earn a An entity created by law.

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dividends Periodic distributions of cash to the stockholders of a firm.

board of directors Group elected by the firm’s stockholders and typically responsible for approving strategic goals and plans, setting general policy, guiding corporate affairs, and approving major expenditures.

return by receiving dividends—periodic distributions of cash—or by realizing gains through increases in share price. Because the money to pay dividends generally comes from the profits that a firm earns, stockholders are sometimes referred to as residual claimants, meaning that stockholders are paid last—after employees, suppliers, tax authorities, and lenders receive what they are owed. If the firm does not generate enough cash to pay everyone else, there is nothing available for stockholders. As noted in the upper portion of Figure 1.1, control of the corporation functions a little like a democracy. The stockholders (owners) vote periodically to elect members of the board of directors and to decide other issues such as amending the corporate charter. The board of directors is typically responsible for approving strategic goals and plans, setting general policy, guiding corporate affairs, and approving major expenditures. Most importantly, the board decides when to hire or fire top managers and establishes compensation packages for the most senior executives. The board consists of “inside” directors, such as key corporate executives, and “outside” or “independent” directors, such as executives from other companies, major shareholders, and national or community leaders. Outside directors for major corporations receive compensation in the form of cash, stock, and stock options. This compensation often totals $100,000 per year or more.

FIGURE 1.1

Stockholders

Corporate Organization The general organization of a corporation and the finance function (which is shown in yellow)

elect Board of Directors

Owners

hires President (CEO)

Vice President Human Resources

Vice President Manufacturing

Vice President Finance (CFO)

Managers

Vice President Marketing

Treasurer

Capital Expenditure Manager

Financial Planning and Fund-Raising Manager

Credit Manager

Cash Manager

Vice President Information Technology

Controller

Foreign Exchange Manager

Pension Fund Manager

Cost Accounting Manager

Tax Manager

Corporate Accounting Manager

Financial Accounting Manager

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president or chief executive officer (CEO) Corporate official responsible for managing the firm’s day-today operations and carrying out the policies established by the board of directors.

limited partnership (LP)

The Role of Managerial Finance

9

The president or chief executive officer (CEO) is responsible for managing day-to-day operations and carrying out the policies established by the board of directors. The CEO reports periodically to the firm’s directors. It is important to note the division between owners and managers in a large corporation, as shown by the dashed horizontal line in Figure 1.1. This separation and some of the issues surrounding it will be addressed in the discussion of the agency issue later in this chapter.

S corporation (S corp)

Other Limited Liability Organizations

limited liability company (LLC)

A number of other organizational forms provide owners with limited liability. The most popular are limited partnership (LP), S corporation (S corp), limited liability company (LLC), and limited liability partnership (LLP). Each represents a specialized form or blending of the characteristics of the organizational forms described previously. What they have in common is that their owners enjoy limited liability, and they typically have fewer than 100 owners.

limited liability partnership (LLP) See “In More Depth” feature.

In more depth To read about Other Limited Liability Organizations, go to www.myfinancelab.com

WHY STUDY MANAGERIAL FINANCE? An understanding of the concepts, techniques, and practices presented throughout this text will fully acquaint you with the financial manager’s activities and decisions. Because the consequences of most business decisions are measured in financial terms, the financial manager plays a key operational role. People in all areas of responsibility—accounting, information systems, management, marketing, operations, and so forth—need a basic awareness of finance so they will understand how to quantify the consequences of their actions. OK, so you’re not planning to major in finance! You still will need to understand how financial managers think to improve your chance of success in your chosen business career. Managers in the firm, regardless of their job descriptions, usually have to provide financial justification for the resources they need to do their job. Whether you are hiring new workers, negotiating an advertising budget, or upgrading the technology used in a manufacturing process, understanding the financial aspects of your actions will help you gain the resources you need to be successful. The “Why This Chapter Matters to You” section that appears on each chapter opening page should help you understand the importance of each chapter in both your professional and personal life. As you study this text, you will learn about the career opportunities in managerial finance, which are briefly described in Table 1.2 on page 10. Although this text focuses on publicly held profit-seeking firms, the principles presented here are equally applicable to private and not-for-profit organizations. The decisionmaking principles developed in this text can also be applied to personal financial decisions. We hope that this first exposure to the exciting field of finance will provide the foundation and initiative for further study and possibly even a future career. 6

REVIEW QUESTIONS 1–1 What is finance? Explain how this field affects all of the activities in

which businesses engage. 1–2 What is the financial services area of finance? Describe the field of

managerial finance.

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Career Opportunities in Managerial Finance

TA B L E 1 . 2 Position

Description

Financial analyst

Prepares the firm’s financial plans and budgets. Other duties include financial forecasting, performing financial comparisons, and working closely with accounting.

Capital expenditures manager

Evaluates and recommends proposed long-term investments. May be involved in the financial aspects of implementing approved investments.

Project finance manager

Arranges financing for approved long-term investments. Coordinates consultants, investment bankers, and legal counsel.

Cash manager

Maintains and controls the firm’s daily cash balances. Frequently manages the firm’s cash collection and disbursement activities and short-term investments and coordinates short-term borrowing and banking relationships.

Credit analyst/manager

Administers the firm’s credit policy by evaluating credit applications, extending credit, and monitoring and collecting accounts receivable.

Pension fund manager

Oversees or manages the assets and liabilities of the employees’ pension fund.

Foreign exchange manager

Manages specific foreign operations and the firm’s exposure to fluctuations in exchange rates.

1–3 Which legal form of business organization is most common? Which

form is dominant in terms of business revenues? 1–4 Describe the roles and the basic relationships among the major parties

in a corporation—stockholders, board of directors, and managers. How are corporate owners rewarded for the risks they take? 1–5 Briefly name and describe some organizational forms other than corporations that provide owners with limited liability. 1–6 Why is the study of managerial finance important to your professional life regardless of the specific area of responsibility you may have within the business firm? Why is it important to your personal life?

LG 3

1.2 Goal of the Firm What goal should managers pursue? There is no shortage of possible answers to this question. Some might argue that managers should focus entirely on satisfying customers. Progress toward this goal could be measured by the market share attained by each of the firm’s products. Others suggest that managers must first inspire and motivate employees; in that case, employee turnover might be the key success metric to watch. Clearly the goal that managers select will affect many of the decisions that they make, so choosing an objective is a critical determinant of how businesses operate.

MAXIMIZE SHAREHOLDER WEALTH Finance teaches that managers’ primary goal should be to maximize the wealth of the firm’s owners—the stockholders. The simplest and best measure of stockholder wealth is the firm’s share price, so most textbooks (ours included) instruct

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The Role of Managerial Finance

managers to take actions that increase the firm’s share price. A common misconception is that when firms strive to make their shareholders happy, they do so at the expense of other constituencies such as customers, employees, or suppliers. This line of thinking ignores the fact that in most cases, to enrich shareholders, managers must first satisfy the demands of these other interest groups. Recall that dividends that stockholders receive ultimately come from the firm’s profits. It is unlikely that a firm whose customers are unhappy with its products, whose employees are looking for jobs at other firms, or whose suppliers are reluctant to ship raw materials will make shareholders rich because such a firm will likely be less profitable in the long run than one that better manages its relations with these stakeholder groups. Therefore, we argue that the goal of the firm, and also of managers, should be to maximize the wealth of the owners for whom it is being operated, or equivalently, to maximize the stock price. This goal translates into a straightforward decision rule for managers—only take actions that are expected to increase the share price. Although that goal sounds simple, implementing it is not always easy. To determine whether a particular course of action will increase or decrease a firm’s share price, managers have to assess what return (that is, cash inflows net of cash outflows) the action will bring and how risky that return might be. Figure 1.2 depicts this process. In fact, we can say that the key variables that managers must consider when making business decisions are return (cash flows) and risk. earnings per share (EPS) The amount earned during the period on behalf of each outstanding share of common stock, calculated by dividing the period’s total earnings available for the firm’s common stockholders by the number of shares of common stock outstanding.

MAXIMIZE PROFIT? It might seem intuitive that maximizing a firm’s share price is equivalent to maximizing its profits, but that is not always correct. Corporations commonly measure profits in terms of earnings per share (EPS), which represent the amount earned during the period on behalf of each outstanding share of common stock. EPS are calculated by dividing the period’s total earnings available for the firm’s common stockholders by the number of shares of common stock outstanding.

FIGURE 1.2 Share Price Maximization Financial decisions and share price

Financial Manager

Financial Decision Alternative or Action

Return? Risk?

Increase Share Price?

No

Reject

Yes

Accept

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Example

1.1

Introduction to Managerial Finance

3

Nick Dukakis, the financial manager of Neptune Manufacturing, a producer of marine engine components, is choosing between two investments, Rotor and Valve. The following table shows the EPS that each investment is expected to have over its 3-year life. Earnings per share (EPS) Investment

Year 1

Year 2

Year 3

Total for years 1, 2, and 3

Rotor Valve

$1.40 0.60

$1.00 1.00

$0.40 1.40

$2.80 3.00

In terms of the profit maximization goal, Valve would be preferred over Rotor because it results in higher total earnings per share over the 3-year period ($3.00 EPS compared with $2.80 EPS). But does profit maximization lead to the highest possible share price? For at least three reasons the answer is often no. First, timing is important. An investment that provides a lower profit in the short run may be preferable to one that earns a higher profit in the long run. Second, profits and cash flows are not identical. The profit that a firm reports is simply an estimate of how it is doing, an estimate that is influenced by many different accounting choices that firms make when assembling their financial reports. Cash flow is a more straightforward measure of the money flowing into and out of the company. Companies have to pay their bills with cash, not earnings, so cash flow is what matters most to financial managers. Third, risk matters a great deal. A firm that earns a low but reliable profit might be more valuable than another firm with profits that fluctuate a great deal (and therefore can be very high or very low at different times). Timing

Because the firm can earn a return on funds it receives, the receipt of funds sooner rather than later is preferred. In our example, in spite of the fact that the total earnings from Rotor are smaller than those from Valve, Rotor provides much greater earnings per share in the first year. The larger returns in year 1 could be reinvested to provide greater future earnings. Cash Flows

Profits do not necessarily result in cash flows available to the stockholders. There is no guarantee that the board of directors will increase dividends when profits increase. In addition, the accounting assumptions and techniques that a firm adopts can sometimes allow a firm to show a positive profit even when its cash outflows exceed its cash inflows. Furthermore, higher earnings do not necessarily translate into a higher stock price. Only when earnings increases are accompanied by increased future cash flows is a higher stock price expected. For example, a firm with a high-quality product sold in a very competitive market could increase its earnings by significantly reducing its equipment maintenance expenditures. The firm’s expenses would be reduced, thereby increasing its profits. But if the reduced maintenance

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13

results in lower product quality, the firm may impair its competitive position, and its stock price could drop as many well-informed investors sell the stock in anticipation of lower future cash flows. In this case, the earnings increase was accompanied by lower future cash flows and therefore a lower stock price. Risk risk The chance that actual outcomes may differ from those expected.

risk averse Requiring compensation to bear risk.

Profit maximization also fails to account for risk—the chance that actual outcomes may differ from those expected. A basic premise in managerial finance is that a trade-off exists between return (cash flow) and risk. Return and risk are, in fact, the key determinants of share price, which represents the wealth of the owners in the firm. Cash flow and risk affect share price differently: Holding risk fixed, higher cash flow is generally associated with a higher share price. In contrast, holding cash flow fixed, higher risk tends to result in a lower share price because the stockholders do not like risk. For example, Apple’s CEO, Steve Jobs, took a leave of absence to battle a serious health issue, and the firm’s stock suffered as a result. This occurred not because of any near-term cash flow reduction but in response to the firm’s increased risk—there’s a chance that the firm’s lack of near-term leadership could result in reduced future cash flows. Simply put, the increased risk reduced the firm’s share price. In general, stockholders are risk averse—that is, they must be compensated for bearing risk. In other words, investors expect to earn higher returns on riskier investments, and they will accept lower returns on relatively safe investments. The key point, which will be fully developed in Chapter 5, is that differences in risk can significantly affect the value of different investments.

WHAT ABOUT STAKEHOLDERS?

stakeholders Groups such as employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm.

Although maximization of shareholder wealth is the primary goal, many firms broaden their focus to include the interests of stakeholders as well as shareholders. Stakeholders are groups such as employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm. A firm with a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders. The goal is not to maximize stakeholder well-being but to preserve it. The stakeholder view does not alter the goal of maximizing shareholder wealth. Such a view is often considered part of the firm’s “social responsibility.” It is expected to provide long-run benefit to shareholders by maintaining positive relationships with stakeholders. Such relationships should minimize stakeholder turnover, conflicts, and litigation. Clearly, the firm can better achieve its goal of shareholder wealth maximization by fostering cooperation with its other stakeholders, rather than conflict with them.

THE ROLE OF BUSINESS ETHICS business ethics Standards of conduct or moral judgment that apply to persons engaged in commerce.

Business ethics are the standards of conduct or moral judgment that apply to persons engaged in commerce. Violations of these standards in finance involve a variety of actions: “creative accounting,” earnings management, misleading financial forecasts, insider trading, fraud, excessive executive compensation, options backdating, bribery, and kickbacks. The financial press has reported many such violations in recent years, involving such well-known companies as

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Apple and Bank of America. As a result, the financial community is developing and enforcing ethical standards. The goal of these ethical standards is to motivate business and market participants to adhere to both the letter and the spirit of laws and regulations concerned with business and professional practice. Most business leaders believe businesses actually strengthen their competitive positions by maintaining high ethical standards. Considering Ethics

Robert A. Cooke, a noted ethicist, suggests that the following questions be used to assess the ethical viability of a proposed action.1 1. Is the action arbitrary or capricious? Does it unfairly single out an individual or group? 2. Does the action violate the moral or legal rights of any individual or group? 3. Does the action conform to accepted moral standards? 4. Are there alternative courses of action that are less likely to cause actual or potential harm? Clearly, considering such questions before taking an action can help to ensure its ethical viability. Today, many firms are addressing the issue of ethics by establishing corporate ethics policies. The Focus on Ethics box provides an example of ethics policies at Google. A major impetus toward the development of ethics policies has been the Sarbanes-Oxley Act of 2002. Frequently, employees are required to sign a formal pledge to uphold the firm’s ethics policies. Such policies typically apply to employee actions in dealing with all corporate stakeholders, including the public. Ethics and Share Price

An effective ethics program can enhance corporate value by producing a number of positive benefits. It can reduce potential litigation and judgment costs, maintain a positive corporate image, build shareholder confidence, and gain the loyalty, commitment, and respect of the firm’s stakeholders. Such actions, by maintaining and enhancing cash flow and reducing perceived risk, can positively affect the firm’s share price. Ethical behavior is therefore viewed as necessary for achieving the firm’s goal of owner wealth maximization. 6

REVIEW QUESTIONS 1–7 What is the goal of the firm and, therefore, of all managers and

employees? Discuss how one measures achievement of this goal. 1–8 For what three basic reasons is profit maximization inconsistent with

wealth maximization?

1. Robert A. Cooke, “Business Ethics: A Perspective,” in Arthur Andersen Cases on Business Ethics (Chicago: Arthur Andersen, September 1991), pp. 2 and 5.

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focus on ETHICS Will Google Live Up to Its Motto? in practice Google offers an inter-

esting case study on value maximization and corporate ethics. In 2004, Google’s founders provided “An Owner’s Manual” for shareholders, which stated that “Google is not a conventional company” and that the company’s ultimate goal “is to develop services that significantly improve the lives of as many people as possible.” The founders stressed that it was not enough for Google to run a successful business but that they want to use the company to make the world a better place. The “Owner’s Manual” also unveiled Google’s corporate motto, “Don’t Be Evil.” The motto is intended to convey Google’s willingness to do the right thing even when doing so requires the firm to sacrifice in the short run. Google’s approach does not appear to be limiting its ability to maximize value—the company’s share price increased from $100 to approximately $500 in 6 years.

Google’s business goal is “instantly delivering relevant information on any topic” to the world. However, when the company launched its search engine in China in early 2006, it agreed to the Chinese government’s request to censor search results. Some observers felt that the opportunity to gain access to the vast Chinese market led Google to compromise its principles. In January 2010, Google announced that the Gmail accounts of Chinese human-rights activists and a number of technology, financial, and defense companies had been hacked. The company threatened to pull out of China unless an agreement on uncensored search results could be reached. Two months later, Google began routing Chinese web searches to their uncensored servers in Hong Kong, a move that was cheered by activists and human-rights groups, but criticized by the Chinese government. In the short term, Google’s shareholders suffered.

During the first quarter of 2010, Google’s share price declined by 8.5 percent, compared to an increase of 45.2 percent for Google’s main rival in China, Baidu.com. Google’s founders seemed to anticipate the current situation in the firm’s “Owner’s Manual.” According to the firm, “If opportunities arise that might cause us to sacrifice short-term results but are in the best long-term interest of our shareholders, we will take those opportunities. We have the fortitude to do this. We would request that our shareholders take the long-term view.” It remains to be seen whether Google’s short-term sacrifice will benefit shareholders in the long run. 3 Is the goal of maximization of shareholder wealth necessarily ethical or unethical? 3 How can Google justify its actions in the short run to its long-run investors?

Source: 2004 Founders’ IPO Letter, http://investor.google.com/corporate/2004/ipo-founders-letter.html

1–9 What is risk? Why must risk as well as return be considered by the

financial manager who is evaluating a decision alternative or action? 1–10 Describe the role of corporate ethics policies and guidelines, and dis-

cuss the relationship that is believed to exist between ethics and share price.

LG 4

LG 5

1.3 Managerial Finance Function People in all areas of responsibility within the firm must interact with finance personnel and procedures to get their jobs done. For financial personnel to make useful forecasts and decisions, they must be willing and able to talk to individuals in other areas of the firm. For example, when considering a new product, the financial manager needs to obtain sales forecasts, pricing guidelines, and advertising and promotion budget estimates from marketing personnel. The managerial finance function can be broadly described by considering its role within the

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organization, its relationship to economics and accounting, and the primary activities of the financial manager.

ORGANIZATION OF THE FINANCE FUNCTION

treasurer The firm’s chief financial manager, who manages the firm’s cash, oversees its pension plans, and manages key risks.

controller The firm’s chief accountant, who is responsible for the firm’s accounting activities, such as corporate accounting, tax management, financial accounting, and cost accounting.

foreign exchange manager The manager responsible for managing and monitoring the firm’s exposure to loss from currency fluctuations.

marginal cost–benefit analysis Economic principle that states that financial decisions should be made and actions taken only when the added benefits exceed the added costs.

Example

1.2

3

The size and importance of the managerial finance function depend on the size of the firm. In small firms, the finance function is generally performed by the accounting department. As a firm grows, the finance function typically evolves into a separate department linked directly to the company president or CEO through the chief financial officer (CFO). The lower portion of the organizational chart in Figure 1.1 on page 8 shows the structure of the finance function in a typical medium- to large-size firm. Reporting to the CFO are the treasurer and the controller. The treasurer (the chief financial manager) typically manages the firm’s cash, investing surplus funds when available and securing outside financing when needed. The treasurer also oversees a firm’s pension plans and manages critical risks related to movements in foreign currency values, interest rates, and commodity prices. The controller (the chief accountant) typically handles the accounting activities, such as corporate accounting, tax management, financial accounting, and cost accounting. The treasurer’s focus tends to be more external, whereas the controller’s focus is more internal. If international sales or purchases are important to a firm, it may well employ one or more finance professionals whose job is to monitor and manage the firm’s exposure to loss from currency fluctuations. A trained financial manager can “hedge,” or protect against such a loss, at a reasonable cost by using a variety of financial instruments. These foreign exchange managers typically report to the firm’s treasurer.

RELATIONSHIP TO ECONOMICS The field of finance is closely related to economics. Financial managers must understand the economic framework and be alert to the consequences of varying levels of economic activity and changes in economic policy. They must also be able to use economic theories as guidelines for efficient business operation. Examples include supply-and-demand analysis, profit-maximizing strategies, and price theory. The primary economic principle used in managerial finance is marginal cost–benefit analysis, the principle that financial decisions should be made and actions taken only when the added benefits exceed the added costs. Nearly all financial decisions ultimately come down to an assessment of their marginal benefits and marginal costs.

Jamie Teng is a financial manager for Nord Department Stores, a large chain of upscale department stores operating primarily in the western United States. She is currently trying to decide whether to replace one of the firm’s computer servers with a new, more sophisticated one that would both speed processing and handle a larger volume of transactions. The new computer would require a cash outlay of $8,000, and the old computer could be sold to net $2,000. The total benefits from the new server (measured in today’s dollars) would be $10,000. The benefits over a similar time period from the old computer (measured in today’s

CHAPTER 1

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17

dollars) would be $3,000. Applying marginal cost–benefit analysis, Jamie organizes the data as follows: Benefits with new computer Less: Benefits with old computer (1) Marginal (added) benefits Cost of new computer Less: Proceeds from sale of old computer (2) Marginal (added) costs Net benefit [(1) 2 (2)]

$10,000 3,000 $ 7,000 $ 8,000 2,000 $ 6,000 $ 1,000

Because the marginal (added) benefits of $7,000 exceed the marginal (added) costs of $6,000, Jamie recommends that the firm purchase the new computer to replace the old one. The firm will experience a net benefit of $1,000 as a result of this action.

RELATIONSHIP TO ACCOUNTING The firm’s finance and accounting activities are closely related and generally overlap. In small firms accountants often carry out the finance function, and in large firms financial analysts often help compile accounting information. However, there are two basic differences between finance and accounting; one is related to the emphasis on cash flows and the other to decision making. Emphasis on Cash Flows

accrual basis In preparation of financial statements, recognizes revenue at the time of sale and recognizes expenses when they are incurred.

cash basis Recognizes revenues and expenses only with respect to actual inflows and outflows of cash.

Example

1.3

3

The accountant’s primary function is to develop and report data for measuring the performance of the firm, assess its financial position, comply with and file reports required by securities regulators, and file and pay taxes. Using generally accepted accounting principles, the accountant prepares financial statements that recognize revenue at the time of sale (whether payment has been received or not) and recognize expenses when they are incurred. This approach is referred to as the accrual basis. The financial manager, on the other hand, places primary emphasis on cash flows, the intake and outgo of cash. He or she maintains the firm’s solvency by planning the cash flows necessary to satisfy its obligations and to acquire assets needed to achieve the firm’s goals. The financial manager uses this cash basis to recognize the revenues and expenses only with respect to actual inflows and outflows of cash. Whether a firm earns a profit or experiences a loss, it must have a sufficient flow of cash to meet its obligations as they come due.

Nassau Corporation, a small yacht dealer, sold one yacht for $100,000 in the calendar year just ended. Nassau originally purchased the yacht for $80,000. Although the firm paid in full for the yacht during the year, at year-end it has yet to collect the $100,000 from the customer. The accounting view and the financial

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view of the firm’s performance during the year are given by the following income and cash flow statements, respectively. Accounting view (accrual basis)

Financial view (cash basis)

Nassau Corporation income statement for the year ended 12/31

Nassau Corporation cash flow statement for the year ended 12/31

Sales revenue Less: Costs Net profit

$100,000 80,000 $ 20,000

Cash inflow Less: Cash outflow Net cash flow

$

0 80,000 ($80,000)

In an accounting sense, Nassau Corporation is profitable, but in terms of actual cash flow it is a financial failure. Its lack of cash flow resulted from the uncollected accounts receivable of $100,000. Without adequate cash inflows to meet its obligations, the firm will not survive, regardless of its level of profits. As the example shows, accrual accounting data do not fully describe the circumstances of a firm. Thus the financial manager must look beyond financial statements to obtain insight into existing or developing problems. Of course, accountants are well aware of the importance of cash flows, and financial managers use and understand accrual-based financial statements. Nevertheless, the financial manager, by concentrating on cash flows, should be able to avoid insolvency and achieve the firm’s financial goals. Individuals do not use accrual concepts. Rather, they rely solely on cash flows to measure their financial outcomes. Generally, individuals plan, monitor, and assess their financial activities using cash flows over a given period, typically a month or a year. Ann Bach projects her cash flows during October 2012 as follows:

Personal Finance Example

1.4

3

Amount Item

Inflow

Net pay received Rent Car payment Utilities Groceries Clothes Dining out Gasoline Interest income Misc. expense Totals

$4,400

Outflow $1,200 450 300 800 750 650 260

220 $4,620

425 $4,835

Ann subtracts her total outflows of $4,835 from her total inflows of $4,620 and finds that her net cash flow for October will be –$215. To cover the $215

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19

shortfall, Ann will have to either borrow $215 (putting it on a credit card is a form of borrowing) or withdraw $215 from her savings. Or she may decide to reduce her outflows in areas of discretionary spending—for example, clothing purchases, dining out, or areas that make up the $425 of miscellaneous expense. Decision Making

The second major difference between finance and accounting has to do with decision making. Accountants devote most of their attention to the collection and presentation of financial data. Financial managers evaluate the accounting statements, develop additional data, and make decisions on the basis of their assessment of the associated returns and risks. Of course, this does not mean that accountants never make decisions or that financial managers never gather data but rather that the primary focuses of accounting and finance are distinctly different.

PRIMARY ACTIVITIES OF THE FINANCIAL MANAGER In addition to ongoing involvement in financial analysis and planning, the financial manager’s primary activities are making investment and financing decisions. Investment decisions determine what types of assets the firm holds. Financing decisions determine how the firm raises money to pay for the assets in which it invests. One way to visualize the difference between a firm’s investment and financing decisions is to refer to the balance sheet shown in Figure 1.3. Investment decisions generally refer to the items that appear on the left-hand side of the balance sheet, and financing decisions relate to the items on the right-hand side. Keep in mind, though, that financial managers make these decisions based on their impact on the value of the firm, not on the accounting principles used to construct a balance sheet. 6

REVIEW QUESTIONS 1–11 In what financial activities does a corporate treasurer engage? 1–12 What is the primary economic principle used in managerial finance? 1–13 What are the major differences between accounting and finance with

respect to emphasis on cash flows and decision making? 1–14 What are the two primary activities of the financial manager that are

related to the firm’s balance sheet?

FIGURE 1.3 Financial Activities Primary activities of the financial manager

Balance Sheet Making Investment Decisions

Current Assets

Current Liabilities

Fixed Assets

Long-Term Funds

Making Financing Decisions

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Introduction to Managerial Finance

1.4 Governance and Agency As noted earlier, the majority of owners of a corporation are normally distinct from its managers. Nevertheless, managers are entrusted to only take actions or make decisions that are in the best interests of the firm’s owners, its shareholders. In most cases, if managers fail to act on the behalf of the shareholders, they will also fail to achieve the goal of maximizing shareholder wealth. To help ensure that managers act in ways that are consistent with the interests of shareholders and mindful of obligations to other stakeholders, firms aim to establish sound corporate governance practices.

CORPORATE GOVERNANCE corporate governance The rules, processes, and laws by which companies are operated, controlled, and regulated.

Corporate governance refers to the rules, processes, and laws by which companies are operated, controlled, and regulated. It defines the rights and responsibilities of the corporate participants such as the shareholders, board of directors, officers and managers, and other stakeholders, as well as the rules and procedures for making corporate decisions. A well-defined corporate governance structure is intended to benefit all corporate stakeholders by ensuring that the firm is run in a lawful and ethical fashion, in accordance with best practices, and subject to all corporate regulations. A firm’s corporate governance is influenced by both internal factors such as the shareholders, board of directors, and officers as well as external forces such as clients, creditors, suppliers, competitors, and government regulations. The corporate organization, depicted in Figure 1.1 on page 8, helps to shape a firm’s corporate governance structure. In particular, the stockholders elect a board of directors, who in turn hire officers or managers to operate the firm in a manner consistent with the goals, plans, and policies established and monitored by the board on behalf of the shareholders. Individual versus Institutional Investors

individual investors Investors who own relatively small quantities of shares so as to meet personal investment goals.

institutional investors Investment professionals, such as banks, insurance companies, mutual funds, and pension funds, that are paid to manage and hold large quantities of securities on behalf of others.

To better understand the role that shareholders play in shaping a firm’s corporate governance, it is helpful to differentiate between the two broad classes of owners—individuals and institutions. Generally, individual investors own relatively small quantities of shares and as a result do not typically have sufficient means to directly influence a firm’s corporate governance. In order to influence the firm, individual investors often find it necessary to act as a group by voting collectively on corporate matters. The most important corporate matter individual investors vote on is the election of the firm’s board of directors. The corporate board’s first responsibility is to the shareholders. The board not only sets policies that specify ethical practices and provide for the protection of stakeholder interests, but it also monitors managerial decision making on behalf of investors. Although they also benefit from the presence of the board of directors, institutional investors have advantages over individual investors when it comes to influencing the corporate governance of a firm. Institutional investors are investment professionals that are paid to manage and hold large quantities of securities on behalf of individuals, businesses, and governments. Institutional investors include banks, insurance companies, mutual funds, and pension funds. Unlike individual investors, institutional investors often monitor and directly influence a

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21

firm’s corporate governance by exerting pressure on management to perform or communicating their concerns to the firm’s board. These large investors can also threaten to exercise their voting rights or liquidate their holdings if the board does not respond positively to their concerns. Because individual and institutional investors share the same goal, individual investors benefit from the shareholder activism of institutional investors. Government Regulation

Sarbanes-Oxley Act of 2002 (SOX) An act aimed at eliminating corporate disclosure and conflict of interest problems. Contains provisions about corporate financial disclosures and the relationships among corporations, analysts, auditors, attorneys, directors, officers, and shareholders.

Unlike the impact that clients, creditors, suppliers, or competitors can have on a particular firm’s corporate governance, government regulation generally shapes the corporate governance of all firms. During the past decade, corporate governance has received increased attention due to several high-profile corporate scandals involving abuse of corporate power and, in some cases, alleged criminal activity by corporate officers. The misdeeds derived from two main types of issues: (1) false disclosures in financial reporting and other material information releases and (2) undisclosed conflicts of interest between corporations and their analysts, auditors, and attorneys and between corporate directors, officers, and shareholders. Asserting that an integral part of an effective corporate governance regime is provisions for civil or criminal prosecution of individuals who conduct unethical or illegal acts in the name of the firm, in July 2002 the U.S. Congress passed the Sarbanes-Oxley Act of 2002 (commonly called SOX). Sarbanes-Oxley is intended to eliminate many of the disclosure and conflict of interest problems that can arise when corporate managers are not held personally accountable for their firm’s financial decisions and disclosures. SOX accomplished the following: established an oversight board to monitor the accounting industry; tightened audit regulations and controls; toughened penalties against executives who commit corporate fraud; strengthened accounting disclosure requirements and ethical guidelines for corporate officers; established corporate board structure and membership guidelines; established guidelines with regard to analyst conflicts of interest; mandated instant disclosure of stock sales by corporate executives; and increased securities regulation authority and budgets for auditors and investigators.

THE AGENCY ISSUE

principal–agent relationship An arrangement in which an agent acts on the behalf of a principal. For example, shareholders of a company (principals) elect management (agents) to act on their behalf.

We know that the duty of the financial manager is to maximize the wealth of the firm’s owners. Shareholders give managers decision-making authority over the firm; thus managers can be viewed as the agents of the firm’s shareholders. Technically, any manager who owns less than 100 percent of the firm is an agent acting on behalf of other owners. This separation of owners and managers is shown by the dashed horizontal line in Figure 1.1 on page 8, and it is representative of the classic principal–agent relationship, where the shareholders are the principals. In general, a contract is used to specify the terms of a principal–agent relationship. This arrangement works well when the agent makes decisions that are in the principal’s best interest but doesn’t work well when the interests of the principal and agent differ. In theory, most financial managers would agree with the goal of shareholder wealth maximization. In reality, however, managers are also concerned with their personal wealth, job security, and fringe benefits. Such concerns may cause managers to make decisions that are not consistent with shareholder

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wealth maximization. For example, financial managers may be reluctant or unwilling to take more than moderate risk if they perceive that taking too much risk might jeopardize their job or reduce their personal wealth.

In more depth

The Agency Problem

To read about Agency Problems, go to www.myfinancelab.com

An important theme of corporate governance is to ensure the accountability of managers in an organization through mechanisms that try to reduce or eliminate the principal–agent problem; however, when these mechanisms fail agency problems arise. Agency problems arise when managers deviate from the goal of maximization of shareholder wealth by placing their personal goals ahead of the goals of shareholders. These problems in turn give rise to agency costs. Agency costs are agency problems costs borne by shareholders due to the presence or avoidance of agency problems, Problems that arise when and in either case represent a loss of shareholder wealth. For example, sharemanagers place personal goals holders incur agency costs when managers fail to make the best investment deciahead of the goals of sion or when managers have to be monitored to ensure that the best investment shareholders. decision is made, because either situation is likely to result in a lower stock agency costs price. Costs arising from agency problems that are borne by shareholders and represent a loss of shareholder wealth.

incentive plans Management compensation plans that tie management compensation to share price; one example involves the granting of stock options.

stock options Options extended by the firm that allow management to benefit from increases in stock prices over time.

performance plans Plans that tie management compensation to measures such as EPS or growth in EPS. Performance shares and/or cash bonuses are used as compensation under these plans.

performance shares Shares of stock given to management for meeting stated performance goals.

cash bonuses Cash paid to management for achieving certain performance goals.

Management Compensation Plans

In addition to the roles played by corporate boards, institutional investors, and government regulations, corporate governance can be strengthened by ensuring that managers’ interests are aligned with those of shareholders. A common approach is to structure management compensation to correspond with firm performance. In addition to combating agency problems, the resulting performancebased compensation packages allow firms to compete for and hire the best managers available. The two key types of managerial compensation plans are incentive plans and performance plans. Incentive plans tie management compensation to share price. One incentive plan grants stock options to management. If the firm’s stock price rises over time, managers will be rewarded by being able to purchase stock at the market price in effect at the time of the grant and then to resell the shares at the prevailing higher market price. Many firms also offer performance plans that tie management compensation to performance measures such as earnings per share (EPS) or growth in EPS. Compensation under these plans is often in the form of performance shares or cash bonuses. Performance shares are shares of stock given to management as a result of meeting the stated performance goals, whereas cash bonuses are cash payments tied to the achievement of certain performance goals. The execution of many compensation plans has been closely scrutinized in light of the past decade’s corporate scandals and financial woes. Both individual and institutional stockholders, as well as the Securities and Exchange Commission (SEC) and other government entities, continue to publicly question the appropriateness of the multimillion-dollar compensation packages that many corporate executives receive. The total compensation in 2009 for the chief executive officers of the 500 biggest U.S. companies is considerable. For example, the three highestpaid CEOs in 2009 were (1) H. Lawrence Culp Jr. of Danaher Corp., who earned $141.36 million; (2) Lawrence J. Ellison of Oracle Corp., who earned $130.23 million; and (3) Aubrey K. McClendon of Chesapeake Energy Corp., who earned

CHAPTER 1

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The Role of Managerial Finance

Matter of fact Forbes.com CEO Performance versus Pay

A

quick check of the most recent Forbes.com reporting of CEO performance versus pay for the top 500 U.S. companies reveals that the highest-paid CEOs are not necessarily the best-performing CEOs. In fact, the total compensation of the top three performing CEOs is less than 4 percent of the total compensation for the top-paid CEOs, all of whom have performances ranked 82nd or worse.

Forbes.com CEO Performance vs. Pay Efficiency ranking

1st 2nd 3rd 90th 82nd 163rd

Chief executive officer

Company

Compensation

Compensation rank

Jeffery H. Boyd Jeffrey P. Bezos Leonard Bell H. Lawrence Culp Jr. Lawrence J. Ellison Aubrey K. McClendon

Priceline.com Amazon.com Alexion Pharmaceuticals Danaher Corp. Oracle Corp. Chesapeake Energy Corp.

$7.49 mil. $1.28 mil. $4.26 mil. $141.36 mil. $130.23 mil. $114.29 mil.

135th 463rd 286th 1st 2nd 3rd

$114.29 million. Tenth on the same list is Jen-Hsun Huang of NVIDIA Corp., who earned $31.40 million. Most studies have failed to find a strong relationship between the performance that companies achieve and the compensation that CEOs receive. During the past few years, publicity surrounding these large compensation packages (without corresponding performance) has driven down executive compensation. Contributing to this publicity is the SEC requirement that publicly traded companies disclose to shareholders and others the amount of compensation to their CEO, CFO, three other highest-paid executives, and directors; the method used to determine it; and a narrative discussion regarding the underlying compensation policies. At the same time, new compensation plans that better link managers’ performance to their compensation are being developed and implemented. As evidence of this trend, consider that the average total compensation for the top three CEOs in 2009 was down slightly more than 69 percent from the average for the top three CEOs in 2006. The average in 2006 was $421.13 million versus an average of $128.63 million in 2009. The Threat of Takeover

When a firm’s internal corporate governance structure is unable to keep agency problems in check, it is likely that rival managers will try to gain control of the firm. Because agency problems represent a misuse of the firm’s resources and impose agency costs on the firm’s shareholders, the firm’s stock is generally depressed, making the firm an attractive takeover target. The threat of takeover by another firm that believes it can enhance the troubled firm’s value by restructuring its management, operations, and financing can provide a strong source of external corporate governance. The constant threat of a takeover tends to motivate management to act in the best interests of the firm’s owners.

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Unconstrained, managers may have other goals in addition to share price maximization, but much of the evidence suggests that share price maximization—the focus of this book—is the primary goal of most firms. 6

REVIEW QUESTIONS 1–15 What is corporate governance? How has the Sarbanes-Oxley Act of 2002

affected it? Explain. 1–16 Define agency problems, and describe how they give rise to agency

costs. Explain how a firm’s corporate governance structure can help avoid agency problems. 1–17 How can the firm structure management compensation to minimize agency problems? What is the current view with regard to the execution of many compensation plans? 1–18 How do market forces—both shareholder activism and the threat of takeover—act to prevent or minimize the agency problem? What role do institutional investors play in shareholder activism?

Summary FOCUS ON VALUE Chapter 1 established the primary goal of the firm—to maximize the wealth of the owners for whom the firm is being operated. For public companies, value at any time is reflected in the stock price. Therefore, management should act only on those opportunities that are expected to create value for owners by increasing the stock price. Doing this requires management to consider the returns (magnitude and timing of cash flows), the risk of each proposed action, and their combined effect on value.

REVIEW OF LEARNING GOALS LG 1

Define finance and the managerial finance function. Finance is the science and art of managing money. It affects virtually all aspects of business. Managerial finance is concerned with the duties of the financial manager working in a business. Financial managers administer the financial affairs of all types of businesses—private and public, large and small, profit seeking and not for profit. They perform such varied tasks as developing a financial plan or budget, extending credit to customers, evaluating proposed large expenditures, and raising money to fund the firm’s operations. LG 2

Describe the legal forms of business organization. The legal forms of business organization are the sole proprietorship, the partnership, and the corporation. The corporation is dominant in terms of business receipts, and its owners are its common and preferred stockholders. Stockholders expect to earn a return by receiving dividends or by realizing gains through increases in share price.

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25

LG 3

Describe the goal of the firm, and explain why maximizing the value of the firm is an appropriate goal for a business. The goal of the firm is to maximize its value and therefore the wealth of its shareholders. Maximizing the value of the firm means running the business in the interest of those who own it—the shareholders. Because shareholders are paid after other stakeholders, it is generally necessary to satisfy the interests of other stakeholders to enrich shareholders. LG 4

Describe how the managerial finance function is related to economics and accounting. All areas of responsibility within a firm interact with finance personnel and procedures. The financial manager must understand the economic environment and rely heavily on the economic principle of marginal cost–benefit analysis to make financial decisions. Financial managers use accounting but concentrate on cash flows and decision making. LG 5

Identify the primary activities of the financial manager. The primary activities of the financial manager, in addition to ongoing involvement in financial analysis and planning, are making investment decisions and making financing decisions. LG 6

Describe the nature of the principal–agent relationship between the owners and managers of a corporation, and explain how various corporate governance mechanisms attempt to manage agency problems. This separation of owners and managers of the typical firm is representative of the classic principal–agent relationship, where the shareholders are the principals and managers are the agents. This arrangement works well when the agent makes decisions that are in the principal’s best interest but can lead to agency problems when the interests of the principal and agent differ. A firm’s corporate governance structure is intended to help ensure that managers act in the best interests of the firm’s shareholders, and other stakeholders, and it is usually influenced by both internal and external factors.

Opener-in-Review In the chapter opener you read about Facebook and its founder’s reluctance to go public. If Zuckerberg is expected to remain the CEO of Facebook after the IPO, why would he be worried about going public?

Self-Test Problem LG 4

ST1–1

(Solution in Appendix)

Emphasis on Cash Flows Worldwide Rugs is a rug importer located in the United States that resells its import products to local retailers. Last year Worldwide Rugs imported $2.5 million worth of rugs from around the world, all of which were paid

26

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for prior to shipping. On receipt of the rugs, the importer immediately resold them to local retailers for $3 million. To allow its retail clients time to resell the rugs, Worldwide Rugs sells to retailers on credit. Prior to the end of its business year, Worldwide Rugs collected 85% of its outstanding accounts receivable. a. What is the accounting profit that Worldwide Rugs generated for the year? b. Did Worldwide Rugs have a successful year from an accounting perspective? c. What is the financial cash flow that Worldwide Rugs generated for the year? d. Did Worldwide Rugs have a successful year from a financial perspective? e. If the current pattern persists, what is your expectation for the future success of Worldwide Rugs?

Warm-Up Exercises

All problems are available in

.

LG 2

E1–1

Ann and Jack have been partners for several years. Their firm, A & J Tax Preparation, has been very successful, as the pair agree on most business-related questions. One disagreement, however, concerns the legal form of their business. Ann has tried for the past 2 years to get Jack to agree to incorporate. She believes that there is no downside to incorporating and sees only benefits. Jack strongly disagrees; he thinks that the business should remain a partnership forever. First, take Ann’s side, and explain the positive side to incorporating the business. Next, take Jack’s side, and state the advantages to remaining a partnership. Lastly, what information would you want if you were asked to make the decision for Ann and Jack?

LG 4

E1–2

The end-of-year parties at Yearling, Inc., are known for their extravagance. Management provides the best food and entertainment to thank the employees for their hard work. During the planning for this year’s bash, a disagreement broke out between the treasurer’s staff and the controller’s staff. The treasurer’s staff contended that the firm was running low on cash and might have trouble paying its bills over the coming months; they requested that cuts be made to the budget for the party. The controller’s staff felt that any cuts were unwarranted as the firm continued to be very profitable. Can both sides be right? Explain your answer.

LG 5

E1–3

You have been made treasurer for a day at AIMCO, Inc. AIMCO develops technology for video conferencing. A manager of the satellite division has asked you to authorize a capital expenditure in the amount of $10,000. The manager states that this expenditure is necessary to continue a long-running project designed to use satellites to allow video conferencing anywhere on the planet. The manager admits that the satellite concept has been surpassed by recent technological advances in telephony, but he feels that AIMCO should continue the project. His reasoning is based on the fact that $2.5 million has already been spent over the past 15 years on this project. Although the project has little chance to be viable, the manager believes it would be a shame to waste the money and time already spent. Use marginal cost–benefit analysis to make your decision regarding whether you should authorize the $10,000 expenditure to continue the project.

The Role of Managerial Finance

CHAPTER 1 LG 6

Problems

E1–4

27

Recently, some branches of Donut Shop, Inc., have dropped the practice of allowing employees to accept tips. Customers who once said, “Keep the change,” now have to get used to waiting for their nickels. Management even instituted a policy of requiring that the change be thrown out if a customer drives off without it. As a frequent customer who gets coffee and doughnuts for the office, you notice that the lines are longer and that more mistakes are being made in your order. Explain why tips could be viewed as similar to stock options and why the delays and incorrect orders could represent a case of agency costs. If tips are gone forever, how could Donut Shop reduce these agency costs?

All problems are available in

.

LG 2

P1–1

Liability comparisons Merideth Harper has invested $25,000 in Southwest Development Company. The firm has recently declared bankruptcy and has $60,000 in unpaid debts. Explain the nature of payments, if any, by Ms. Harper in each of the following situations. a. Southwest Development Company is a sole proprietorship owned by Ms. Harper. b. Southwest Development Company is a 50–50 partnership of Ms. Harper and Christopher Black. c. Southwest Development Company is a corporation.

LG 4

P1–2

Accrual income versus cash flow for a period Thomas Book Sales, Inc., supplies textbooks to college and university bookstores. The books are shipped with a proviso that they must be paid for within 30 days but can be returned for a full refund credit within 90 days. In 2009, Thomas shipped and billed book titles totaling $760,000. Collections, net of return credits, during the year totaled $690,000. The company spent $300,000 acquiring the books that it shipped. a. Using accrual accounting and the preceding values, show the firm’s net profit for the past year. b. Using cash accounting and the preceding values, show the firm’s net cash flow for the past year. c. Which of these statements is more useful to the financial manager? Why? Personal Finance Problem

LG 4

P1–3

Cash flows It is typical for Jane to plan, monitor, and assess her financial position using cash flows over a given period, typically a month. Jane has a savings account, and her bank loans money at 6% per year while it offers short-term investment rates of 5%. Jane’s cash flows during August were as follows: Item Clothes Interest received Dining out Groceries Salary Auto payment Utilities Mortgage Gas

Cash inflow

Cash outflow $1,000

$

450 500 800 4,500 355 280 1,200 222

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a. b. c. d. LG 3

Determine Jane’s total cash inflows and cash outflows. Determine the net cash flow for the month of August. If there is a shortage, what are a few options open to Jane? If there is a surplus, what would be a prudent strategy for her to follow?

LG 5

P1–4

Marginal cost–benefit analysis and the goal of the firm Ken Allen, capital budgeting analyst for Bally Gears, Inc., has been asked to evaluate a proposal. The manager of the automotive division believes that replacing the robotics used on the heavy truck gear line will produce total benefits of $560,000 (in today’s dollars) over the next 5 years. The existing robotics would produce benefits of $400,000 (also in today’s dollars) over that same time period. An initial cash investment of $220,000 would be required to install the new equipment. The manager estimates that the existing robotics can be sold for $70,000. Show how Ken will apply marginal cost–benefit analysis techniques to determine the following: a. The marginal (added) benefits of the proposed new robotics. b. The marginal (added) cost of the proposed new robotics. c. The net benefit of the proposed new robotics. d. What should Ken Allen recommend that the company do? Why? e. What factors besides the costs and benefits should be considered before the final decision is made?

LG 6

P1–5

Identifying agency problems, costs, and resolutions Explain why each of the following situations is an agency problem and what costs to the firm might result from it. Suggest how the problem might be dealt with short of firing the individual(s) involved. a. The front desk receptionist routinely takes an extra 20 minutes of lunch time to run personal errands. b. Division managers are padding cost estimates so as to show short-term efficiency gains when the costs come in lower than the estimates. c. The firm’s chief executive officer has had secret talks with a competitor about the possibility of a merger in which she would become the CEO of the combined firms. d. A branch manager lays off experienced full-time employees and staffs customer service positions with part-time or temporary workers to lower employment costs and raise this year’s branch profit. The manager’s bonus is based on profitability.

LG 3

P1–6

ETHICS PROBLEM What does it mean to say that managers should maximize shareholder wealth “subject to ethical constraints”? What ethical considerations might enter into decisions that result in cash flow and stock price effects that are less than they might otherwise have been?

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29

Spreadsheet Exercise Assume that Monsanto Corporation is considering the renovation and/or replacement of some of its older and outdated carpet-manufacturing equipment. Its objective is to improve the efficiency of operations in terms of both speed and reduction in the number of defects. The company’s finance department has compiled pertinent data that will allow it to conduct a marginal cost–benefit analysis for the proposed equipment replacement. The cash outlay for new equipment would be approximately $600,000. The net book value of the old equipment and its potential net selling price add up to $250,000. The total benefits from the new equipment (measured in today’s dollars) would be $900,000. The benefits of the old equipment over a similar period of time (measured in today’s dollars) would be $300,000.

TO DO Create a spreadsheet to conduct a marginal cost–benefit analysis for Monsanto Corporation, and determine the following: a. b. c. d.

The marginal (added) benefits of the proposed new equipment. The marginal (added) cost of the proposed new equipment. The net benefit of the proposed new equipment. What would you recommend that the firm do? Why?

Visit www.myfinancelab.com for Chapter Case: Assessing the Goal of Sports Products, Inc., Group Exercises, and numerous online resources.

2

The Financial Market Environment

Learning Goals

Why This Chapter Matters to You

LG 1 Understand the role that financial

In your professional life

institutions play in managerial finance.

LG 2 Contrast the functions of financial

institutions and financial markets.

LG 3 Describe the differences between

the capital markets and the money markets.

ACCOUNTING You need to understand how business income is taxed and the difference between average and marginal tax rates. INFORMATION SYSTEMS You need to understand how information flows between the firm and financial markets. MANAGEMENT You need to understand why healthy financial institutions are an integral part of a healthy economy and how a crisis in the financial sector can spread and affect almost any type of business.

LG 4 Explain the root causes of the

MARKETING You need to understand why it is important for firms to communicate about their operating results with external investors and how regulations constrain the types of communication that occur.

LG 5 Understand the major regulations

OPERATIONS You need to understand why external financing is, for most firms, an essential aspect of ongoing operations.

LG 6 Discuss business taxes and their

Making financial transactions will be a regular occurrence throughout your entire life. These transactions may be as simple as depositing your paycheck in a bank or as complex as deciding how to allocate the money you save for retirement among different investment options. Many of these transactions have important tax consequences, which vary over time and from one type of transaction to another. The content in this chapter will help you make better decisions when you engage in any of these transactions.

2008 financial crisis and recession.

and regulatory bodies that affect financial institutions and markets.

importance in financial decisions.

30

In your personal life

JPMorgan Chase & Co. Cut to the Chase

S

ince the recession of the early 1990s, business had been booming for JPMorgan Chase, one of

the leading investment banking firms on Wall Street. After hitting a low of roughly $2 per share in October 1990, Chase stock went on a tear, rising at a rate of about 21 percent per year and hitting the $50 range by April 2007. The bank’s investors enjoyed increasing dividend payments along with the rising stock price. JPMorgan Chase increased its dividend payout from $0.0833 per share in December 1990 to $0.38 per share in July 2007, an increase of more than 350 percent. Trouble was brewing, however. In the summer of 2007, data began to emerge that prices of single-family homes were falling in many U.S. cities and homeowners were starting to default on their mortgages. Rumors swirled that JPMorgan and other banks held large investments in securities tied to residential mortgages. On September 15, 2008, the venerable investment banking firm, Lehman Brothers, filed for bankruptcy, and JPMorgan shares fell 10 percent in a single day. Bad news about the economy and the financial sector continued through the fall, and Chase’s stock hit a low point on November 21 near $20, losing more than half its value in roughly 18 months. All of this prompted JPMorgan management to make two difficult decisions. The first was to accept a $25 billion “investment” (some referred to it as a bailout) from the U.S. Treasury on October 28, 2008. The second was to cut its quarterly dividend by almost 87 percent, from $0.38 to $0.05 per share. These decisions, combined with a slowly improving economy, helped JPMorgan survive the 2008 financial crisis and the subsequent recession. By the summer of 2009, JPMorgan Chase repaid the $25 billion (with interest) that it had received from the government, and the bank’s stock had recovered most of the value that it had lost.

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Introduction to Managerial Finance

2.1 Financial Institutions and Markets Most successful firms have ongoing needs for funds. They can obtain funds from external sources in three ways. The first source is through a financial institution that accepts savings and transfers them to those that need funds. A second source is through financial markets, organized forums in which the suppliers and demanders of various types of funds can make transactions. A third source is through private placement. Because of the unstructured nature of private placements, here we focus primarily on the role of financial institutions and financial markets in facilitating business financing.

FINANCIAL INSTITUTIONS financial institution An intermediary that channels the savings of individuals, businesses, and governments into loans or investments.

Financial institutions serve as intermediaries by channeling the savings of individuals, businesses, and governments into loans or investments. Many financial institutions directly or indirectly pay savers interest on deposited funds; others provide services for a fee (for example, checking accounts for which customers pay service charges). Some financial institutions accept customers’ savings deposits and lend this money to other customers or to firms; others invest customers’ savings in earning assets such as real estate or stocks and bonds; and some do both. Financial institutions are required by the government to operate within established regulatory guidelines. Key Customers of Financial Institutions

For financial institutions, the key suppliers of funds and the key demanders of funds are individuals, businesses, and governments. The savings that individual consumers place in financial institutions provide these institutions with a large portion of their funds. Individuals not only supply funds to financial institutions but also demand funds from them in the form of loans. However, individuals as a group are the net suppliers for financial institutions: They save more money than they borrow. Business firms also deposit some of their funds in financial institutions, primarily in checking accounts with various commercial banks. Like individuals, firms borrow funds from these institutions, but firms are net demanders of funds: They borrow more money than they save. Governments maintain deposits of temporarily idle funds, certain tax payments, and Social Security payments in commercial banks. They do not borrow funds directly from financial institutions, although by selling their debt securities to various institutions, governments indirectly borrow from them. The government, like business firms, is typically a net demander of funds: It typically borrows more than it saves. We’ve all heard about the federal budget deficit. Major Financial Institutions

The major financial institutions in the U.S. economy are commercial banks, savings and loans, credit unions, savings banks, insurance companies, mutual funds, and pension funds. These institutions attract funds from individuals, businesses, and governments, combine them, and make loans available to individuals and businesses.

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COMMERCIAL BANKS, INVESTMENT BANKS, AND THE SHADOW BANKING SYSTEM Commercial banks are among the most important financial institutions in the economy because they provide savers with a secure place to invest funds and they offer both individuals and companies loans to finance investments, such as the purchase of a new home or the expansion of a business. Investment banks are institutions that (1) assist companies in raising capital, (2) advise firms on major transactions such as mergers or financial restructurings, and (3) engage in trading investment banks and market making activities. Institutions that assist The traditional business model of a commercial bank—taking in and paying companies in raising capital, interest on deposits and investing or lending those funds back out at higher advise firms on major interest rates—works to the extent that depositors believe that their investments transactions such as mergers or are secure. Since the 1930s, the U.S. government has given some assurance to financial restructurings, and engage in trading and market depositors that their money is safe by providing deposit insurance (currently up making activities. to $250,000 per depositor). Deposit insurance was put in place in response to the banking runs or panics that were part of the Great Depression. The same act of Glass-Steagall Act Congress that introduced deposit insurance, the Glass-Steagall Act, also created a An act of Congress in 1933 that created the federal deposit separation between commercial banks and investment banks, meaning that an insurance program and institution engaged in taking in deposits could not also engage in the somewhat separated the activities of riskier activities of securities underwriting and trading. commercial and investment Commercial and investment banks remained essentially separate for more than banks. 50 years, but in the late 1990s Glass-Steagall was repealed. Companies that had formerly engaged only in the traditional activities of a commercial bank began competing with investment banks for underwriting and other services. In addition, the 1990s witnessed tremendous growth in what has come to be known as the shadow shadow banking system banking system. The shadow banking system describes a group of institutions that A group of institutions that engage in lending activities, much like traditional banks, but these institutions do engage in lending activities, not accept deposits and are therefore not subject to the same regulations as tradimuch like traditional banks, but tional banks.1 For example, an institution such as a pension fund might have excess do not accept deposits and cash to invest, and a large corporation might need short-term financing to cover seatherefore are not subject to the same regulations as traditional sonal cash flow needs. A business like Lehman Brothers acted as an intermediary between these two parties, helping to facilitate a loan, and thereby became part of banks. the shadow banking system. In March 2010, Treasury Secretary Timothy Geithner noted that at its peak the shadow banking system financed roughly $8 trillion in assets and was roughly as large as the traditional banking system. commercial banks

Institutions that provide savers with a secure place to invest their funds and that offer loans to individual and business borrowers.

Matter of fact Consolidation in the U.S. Banking Industry

T

he U.S. banking industry has been going through a long period of consolidation. According to the FDIC, the number of commercial banks in the United States declined from 11,463 in 1992 to 8,012 at the end of 2009, a decline of 30 percent. The decline is concentrated among small community banks, which larger institutions have been acquiring at a rapid pace.

1. The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010 in response to the financial crisis and recession of 2008–2009. This legislation will likely have a dramatic impact on the regulation of both traditional and shadow banking institutions, but it is too early to tell exactly what the new law’s effects will be. In the wake of the law’s passage, many commentators suggested that the law did not exercise enough oversight of the shadow banking system to prevent a financial meltdown similar to the one that motivated the law’s enactment.

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FINANCIAL MARKETS financial markets Forums in which suppliers of funds and demanders of funds can transact business directly.

private placement The sale of a new security directly to an investor or group of investors.

public offering The sale of either bonds or stocks to the general public.

primary market Financial market in which securities are initially issued; the only market in which the issuer is directly involved in the transaction.

secondary market Financial market in which preowned securities (those that are not new issues) are traded.

Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. Whereas the loans made by financial institutions are granted without the direct knowledge of the suppliers of funds (savers), suppliers in the financial markets know where their funds are being lent or invested. The two key financial markets are the money market and the capital market. Transactions in short-term debt instruments, or marketable securities, take place in the money market. Long-term securities—bonds and stocks—are traded in the capital market. To raise money, firms can use either private placements or public offerings. A private placement involves the sale of a new security directly to an investor or group of investors, such as an insurance company or pension fund. Most firms, however, raise money through a public offering of securities, which is the sale of either bonds or stocks to the general public. When a company or government entity sells stocks or bonds to investors and receives cash in return, it is said to have sold securities in the primary market. After the primary market transaction occurs, any further trading in the security does not involve the issuer directly, and the issuer receives no additional money from these subsequent transactions. Once the securities begin to trade between investors, they become part of the secondary market. On large stock exchanges, billions of shares may trade between buyers and sellers on a single day, and these are all secondary market transactions. Money flows from the investors buying stocks to the investors selling them, and the company whose stock is being traded is largely unaffected by the transactions. The primary market is the one in which “new” securities are sold. The secondary market can be viewed as a “preowned” securities market.

THE RELATIONSHIP BETWEEN INSTITUTIONS AND MARKETS Financial institutions actively participate in the financial markets as both suppliers and demanders of funds. Figure 2.1 depicts the general flow of funds through and between financial institutions and financial markets as well as the

Funds

Funds

Financial Institutions

Deposits/Shares

Loans

Suppliers of Funds

Securities

Funds

Private Placement

Demanders of Funds

Securities

Flow of Funds Flow of funds for financial institutions and markets

Funds

FIGURE 2.1

Funds Securities

Financial Markets

Funds Securities

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35

mechanics of private placement transactions. Domestic or foreign individuals, businesses, and governments may supply and demand funds. We next briefly discuss the money market, including its international equivalent—the Eurocurrency market. We then end this section with a discussion of the capital market, which is of key importance to the firm.

THE MONEY MARKET money market A financial relationship created between suppliers and demanders of short-term funds.

marketable securities Short-term debt instruments, such as U.S. Treasury bills, commercial paper, and negotiable certificates of deposit issued by government, business, and financial institutions, respectively.

Eurocurrency market International equivalent of the domestic money market.

The money market is created by a financial relationship between suppliers and demanders of short-term funds (funds with maturities of one year or less). The money market exists because some individuals, businesses, governments, and financial institutions have temporarily idle funds that they wish to invest in a relatively safe, interest-bearing asset. At the same time, other individuals, businesses, governments, and financial institutions find themselves in need of seasonal or temporary financing. The money market brings together these suppliers and demanders of short-term funds. Most money market transactions are made in marketable securities— short-term debt instruments, such as U.S. Treasury bills, commercial paper, and negotiable certificates of deposit issued by government, business, and financial institutions, respectively. Investors generally consider marketable securities to be among the least risky investments available. Marketable securities are described in Chapter 15. The international equivalent of the domestic money market is called the Eurocurrency market. This is a market for short-term bank deposits denominated in U.S. dollars or other major currencies. Eurocurrency deposits arise when a corporation or individual makes a bank deposit in a currency other than the local currency of the country where the bank is located. If, for example, a multinational corporation were to deposit U.S. dollars in a London bank, this would create a Eurodollar deposit (a dollar deposit at a bank in Europe). Nearly all Eurodollar deposits are time deposits. This means that the bank would promise to repay the deposit, with interest, at a fixed date in the future—say, in 6 months. During the interim, the bank is free to lend this dollar deposit to creditworthy corporate or government borrowers. If the bank cannot find a borrower on its own, it may lend the deposit to another international bank.

THE CAPITAL MARKET capital market A market that enables suppliers and demanders of long-term funds to make transactions.

The capital market is a market that enables suppliers and demanders of long-term funds to make transactions. Included are securities issues of business and government. The backbone of the capital market is formed by the broker and dealer markets that provide a forum for bond and stock transactions. International capital markets also exist. Key Securities Traded: Bonds and Stocks

bond Long-term debt instrument used by business and government to raise large sums of money, generally from a diverse group of lenders.

The key capital market securities are bonds (long-term debt) and both common stock and preferred stock (equity, or ownership). Bonds are long-term debt instruments used by business and government to raise large sums of money, generally from a diverse group of lenders. Corporate bonds typically pay interest semiannually (every 6 months) at a stated coupon interest rate. They have an initial maturity of from 10 to 30 years, and a par, or

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face, value of $l,000 that must be repaid at maturity. Bonds are described in detail in Chapter 7. Example

2.1

3

preferred stock A special form of ownership having a fixed periodic dividend that must be paid prior to payment of any dividends to common stockholders.

broker market The securities exchanges on which the two sides of a transaction, the buyer and seller, are brought together to trade securities.

securities exchanges Organizations that provide the marketplace in which firms can raise funds through the sale of new securities and purchasers can resell securities.

dealer market The market in which the buyer and seller are not brought together directly but instead have their orders executed by securities dealers that “make markets” in the given security.

market makers Securities dealers who “make markets” by offering to buy or sell certain securities at stated prices.

Nasdaq market An all-electronic trading platform used to execute securities trades.

over-the-counter (OTC) market Market where smaller, unlisted securities are traded.

Lakeview Industries, a major microprocessor manufacturer, has issued a 9% coupon interest rate, 20-year bond with a $1,000 par value that pays interest semiannually. Investors who buy this bond receive the contractual right to $90 annual interest (9% coupon interest rate * $1,000 par value) distributed as $45 at the end of each 6 months (1/2 * $90) for 20 years, plus the $1,000 par value at the end of year 20. As noted earlier, shares of common stock are units of ownership, or equity, in a corporation. Common stockholders earn a return by receiving dividends— periodic distributions of cash—or by realizing increases in share price. Preferred stock is a special form of ownership that has features of both a bond and common stock. Preferred stockholders are promised a fixed periodic dividend that must be paid prior to payment of any dividends to common stockholders. In other words, preferred stock has “preference” over common stock. Preferred stock and common stock are described in detail in Chapter 8. See the Focus on Practice box for the story of one legendary stock price and the equally legendary man who brought it about. Broker Markets and Dealer Markets

By far the vast majority of trades made by individual investors take place in the secondary market. When you look at the secondary market on the basis of how securities are traded, you will find you can essentially divide the market into two segments: broker markets and dealer markets. The key difference between broker and dealer markets is a technical point dealing with the way trades are executed. That is, when a trade occurs in a broker market, the two sides to the transaction, the buyer and the seller, are brought together and the trade takes place at that point: Party A sells his or her securities directly to the buyer, Party B. In a sense, with the help of a broker, the securities effectively change hands on the floor of the exchange. The broker market consists of national and regional securities exchanges, which are organizations that provide a marketplace in which firms can raise funds through the sale of new securities and purchasers can resell securities. In contrast, when trades are made in a dealer market, the buyer and the seller are never brought together directly. Instead, market makers execute the buy/sell orders. Market makers are securities dealers who “make markets” by offering to buy or sell certain securities at stated prices. Essentially, two separate trades are made: Party A sells his or her securities (in, say, Dell) to a dealer, and Party B buys his or her securities (in Dell) from another, or possibly even the same, dealer. Thus, there is always a dealer (market maker) on one side of a dealer–market transaction. The dealer market is made up of both the Nasdaq market, an allelectronic trading platform used to execute securities trades, and the overthe-counter (OTC) market, where smaller, unlisted securities are traded. Broker Markets If you are like most people, when you think of the “stock market” the first name to come to mind is the New York Stock Exchange, known currently as the NYSE Euronext after a series of mergers that expanded the

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focus on PRACTICE Berkshire Hathaway—Can Buffett Be Replaced? in practice In early 1980,

investors could buy one share of Berkshire Hathaway Class A common stock (stock symbol: BRKA) for $285. That may have seemed expensive at the time, but by September 2010 the price of just one share had climbed to $125,000. The wizard behind such phenomenal growth in shareholder value is the chairman of Berkshire Hathaway, Warren Buffett, nicknamed the Oracle of Omaha. With his partner, Vice-Chairman Charlie Munger, Buffett runs a large conglomerate of dozens of subsidiaries with 222,000 employees and more than $112 billion in annual revenues. He makes it look easy. In his words, “I’ve taken the easy route, just sitting back and working through great managers who run their own shows. My only tasks are to cheer them on, sculpt and harden our corporate culture, and make major capital-allocation decisions. Our managers have returned this trust by working hard and effectively.”a a

Buffett’s style of corporate leadership seems rather laid back, but behind that “aw-shucks” manner is one of the best analytical minds in business. He believes in aligning managerial incentives with performance. Berkshire employs many different incentive arrangements, with their terms depending on such elements as the economic potential or capital intensity of a CEO’s business. Whatever the compensation arrangement, Buffett tries to keep it both simple and fair. Buffett himself receives an annual salary of $100,000—not much in this age of supersized CEO compensation packages. Listed for many years among the world’s wealthiest people, Buffett has donated most of his Berkshire stock to the Bill and Melinda Gates Foundation. Berkshire’s annual report is a mustread for many investors due to the popularity of Buffett’s annual letter to shareholders with his homespun take on such topics as investing, corporate governance, and corporate leadership.

Shareholder meetings in Omaha, Nebraska, have turned into cultlike gatherings, with thousands traveling to listen to Buffett answer questions from shareholders. One question that has been firmly answered is the question of Mr. Buffett’s ability to create shareholder value. The next question that needs to be answered is whether Berkshire Hathaway can successfully replace Buffett (age 80) and Munger (age 86). In October 2010, Berkshire hired hedge fund manager Todd Combs to handle a significant portion of the firm’s investments. Berkshire shareholders hope that Buffett’s special wisdom applies as well to identifying new managerial talent as it does to making strategic investment decisions. 3 The share price of BRKA has never been split. Why might the company refuse to split its shares to make them more affordable to average investors?

Berkshire Hathaway, Inc., “Letter to Shareholders of Berkshire Hathaway, Inc.,” 2006 Annual Report, p. 4.

exchange’s global reach. In point of fact, the NYSE Euronext is the dominant broker market. The American Stock Exchange (AMEX), which is another national exchange, and several so-called regional exchanges are also broker markets. These exchanges account for about 60 percent of the total dollar volume of all shares traded in the U.S. stock market. In broker markets all the trading takes place on centralized trading floors. Most exchanges are modeled after the New York Stock Exchange. For a firm’s securities to be listed for trading on a stock exchange, a firm must file an application for listing and meet a number of requirements. For example, to be eligible for listing on the NYSE, a firm must have at least 400 stockholders owning 100 or more shares; a minimum of 1.1 million shares of publicly held stock outstanding; pretax earnings of at least $10 million over the previous 3 years, with at least $2 million in the previous 2 years; and a minimum market value of public shares of $100 million. Clearly, only large, widely held firms are candidates for NYSE listing. Once placed, an order to buy or sell on the NYSE can be executed in minutes, thanks to sophisticated telecommunication devices. New Internet-based brokerage systems enable investors to place their buy and sell orders electronically.

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Information on publicly traded securities is reported in various media, both print, such as the Wall Street Journal, and electronic, such as MSN Money (www.moneycentral.msn.com).

bid price The highest price offered to purchase a security.

ask price The lowest price at which a security is offered for sale.

Dealer Markets One of the key features of the dealer market is that it has no centralized trading floors. Instead, it is made up of a large number of market makers who are linked together via a mass-telecommunications network. Each market maker is actually a securities dealer who makes a market in one or more securities by offering to buy or sell them at stated bid/ask prices. The bid price and ask price represent, respectively, the highest price offered to purchase a given security and the lowest price at which the security is offered for sale. In effect, an investor pays the ask price when buying securities and receives the bid price when selling them. As described earlier, the dealer market is made up of both the Nasdaq market and the over-the-counter (OTC) market, which together account for about 40 percent of all shares traded in the U.S. market—with the Nasdaq accounting for the overwhelming majority of those trades. (As an aside, the primary market is also a dealer market because all new issues are sold to the investing public by securities dealers, acting on behalf of the investment banker.) The largest dealer market consists of a select group of stocks that are listed and traded on the National Association of Securities Dealers Automated Quotation System, typically referred to as Nasdaq. Founded in 1971, Nasdaq had its origins in the OTC market but is today considered a totally separate entity that’s no longer a part of the OTC market. In fact, in 2006 Nasdaq was formally recognized by the SEC as a “listed exchange,” essentially giving it the same stature and prestige as the NYSE. International Capital Markets

Although U.S. capital markets are by far the world’s largest, there are important debt and equity markets outside the United States. In the Eurobond market, corEurobond market The market in which porations and governments typically issue bonds denominated in dollars and sell corporations and governments them to investors located outside the United States. A U.S. corporation might, for typically issue bonds example, issue dollar-denominated bonds that would be purchased by investors denominated in dollars and sell in Belgium, Germany, or Switzerland. Through the Eurobond market, issuing them to investors located firms and governments can tap a much larger pool of investors than would be outside the United States. generally available in the local market.

Matter of fact NYSE Euronext is the World’s Largest Stock Exchange

A

ccording to the World Federation of Exchanges, the largest stock market in the world, as measured by the total market value of securities listed on that market, is the NYSE Euronext, with listed securities worth more than $11.8 trillion in the United States and $2.9 trillion in Europe. Next largest is the London Stock Exchange, with securities valued at £1.7 trillion, which is equivalent to $2.8 trillion given the exchange rate between pounds and dollars prevailing at the end of 2009.

CHAPTER 2

foreign bond A bond that is issued by a foreign corporation or government and is denominated in the investor’s home currency and sold in the investor’s home market.

international equity market A market that allows corporations to sell blocks of shares to investors in a number of different countries simultaneously.

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The foreign bond market is an international market for long-term debt securities. A foreign bond is a bond issued by a foreign corporation or government that is denominated in the investor’s home currency and sold in the investor’s home market. A bond issued by a U.S. company that is denominated in Swiss francs and sold in Switzerland is a foreign bond. Although the foreign bond market is smaller than the Eurobond market, many issuers have found it to be an attractive way of tapping debt markets around the world. Finally, the international equity market allows corporations to sell blocks of shares to investors in a number of different countries simultaneously. This market enables corporations to raise far larger amounts of capital than they could in any single market. International equity sales have been indispensable to governments that have sold state-owned companies to private investors. The Role of Capital Markets

efficient market A market that allocates funds to their most productive uses as a result of competition among wealth-maximizing investors and that determines and publicizes prices that are believed to be close to their true value.

In more depth To read about The Efficient Markets Hypothesis, go to www.myfinancelab.com

From a firm’s perspective, the role of a capital market is to be a liquid market where firms can interact with investors to obtain valuable external financing resources. From investors’ perspectives, the role of a capital market is to be an efficient market that allocates funds to their most productive uses. This is especially true for securities that are actively traded in broker or dealer markets, where the competition among wealth-maximizing investors determines and publicizes prices that are believed to be close to their true value. The price of an individual security is determined by the interaction between buyers and sellers in the market. If the market is efficient, the price of a stock is an unbiased estimate of its true value, and changes in the price reflect new information that investors learn about and act on. For example, suppose a certain stock currently trades at $40 per share. If this company announces that sales of a new product have been higher than expected, investors will raise their estimate of what the stock is truly worth. At $40, the stock is a relative bargain, so there will temporarily be more buyers than sellers wanting to trade the stock, and its price will have to rise to restore equilibrium in the market. The more efficient the market is, the more rapidly this whole process works. In theory, even information known only to insiders may become incorporated in stock prices as the Focus on Ethics box on page 40 explains. Not everyone agrees that prices in financial markets are as efficient as described in the preceding paragraph. Advocates of behavioral finance, an emerging field that blends ideas from finance and psychology, argue that stock prices and prices of other securities can deviate from their true values for extended periods. These people point to episodes such as the huge run-up and subsequent collapse of the prices of Internet stocks in the late 1990s and the failure of markets to accurately assess the risk of mortgage-backed securities in the more recent financial crisis as examples of the principle that stock prices sometimes can be wildly inaccurate measures of value. Just how efficient are the prices in financial markets? That is a question that will be debated for a long time. It is clear that prices do move in response to new information, and for most investors and corporate managers the best advice is probably to be cautious when betting against the market. Identifying securities that the market has over- or undervalued is extremely difficult, and very few people have demonstrated an ability to bet against the market correctly for an extended time.

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focus on ETHICS The Ethics of Insider Trading in practice On December 27,

2001, Martha Stewart sold nearly 4,000 shares in ImClone Systems stock. The following day, the Food and Drug Administration delivered some bad news regarding ImClone’s cancer drug, Erbitux, and ImClone’s stock price dropped substantially. It appeared that Martha Stewart had picked the right time to sell. Martha Stewart was not the only ImClone shareholder who was selling. The company’s founder, Sam Waksal, also tried to sell his stock (brokers refused to execute the sales), as did his daughter. The U.S. Securities and Exchange Commission and the Federal Bureau of Investigation were soon looking into the transactions. Sam Waksal ultimately received an 87-month prison sentence and $3 million in fines for insider trading and tax evasion. Martha Stewart was convicted of conspiracy, obstruction, and making false statements to federal investigators and served 5 months in jail, 5 months of home confinement, and 2 years of probation and paid a $30,000 fine. In addition, she was forced to resign as chairman and CEO of the company a

she had founded, Martha Stewart Living Omnimedia. On the day of her conviction, the company’s shares lost 23 percent of their value. Laws prohibiting insider trading were established in the United States in the 1930s. These laws are designed to ensure that all investors have access to relevant information on the same terms. However, many market participants believe that insider trading should be permitted. Their argument is rooted in the efficient-market hypothesis (EMH). According to the EMH, stock prices fully reflect all publicly available information. Of course, a significant amount of information about every company is not publicly available. Thus, stock prices may not accurately reflect all that is known about a company. Those who argue for allowing insider trading believe that market prices influence the allocation of resources among companies. Firms with higher stock prices find it easier to raise capital, for example. Therefore, it is important that market prices reflect as much information as possible. Advocates of allowing insider trading argue that investors would quickly

convert inside information into publicly available information if insider trading were permitted. If, for example, Sam Waksal had been permitted to sell his stock after learning of the FDA’s decision, market participants might view his actions and come to the judgment that ImClone’s prospects had dimmed. Of course, the other necessary condition is that outsiders can observe the stock market transactions of insiders. Interestingly, Eugene Fama, who is viewed by many as the father of the efficient-market hypothesis, does not believe that insider trading should be permitted.a Fama believes that allowing insider trading creates a moral hazard problem. For example, if insiders are allowed to trade on proprietary information, they may have the incentive to hold back information for their personal gain. 3 If efficiency is the goal of financial markets, is allowing or disallowing insider trading more unethical? 3 Does allowing insider trading create an ethical dilemma for insiders?

www.dimensional.com/famafrench/2010/04/qa-is-insider-trading-beneficial.html

6

REVIEW QUESTIONS 2–1 Who are the key participants in the transactions of financial institu-

tions? Who are net suppliers, and who are net demanders? 2–2 What role do financial markets play in our economy? What are primary

and secondary markets? What relationship exists between financial institutions and financial markets? 2–3 What is the money market? What is the Eurocurrency market? 2–4 What is the capital market? What are the primary securities traded in it? 2–5 What are broker markets? What are dealer markets? How do they differ? 2–6 Briefly describe the international capital markets, particularly the Eurobond market and the international equity market. 2–7 What are efficient markets? What determines the price of an individual security in such a market?

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41

2.2 The Financial Crisis In the summer and fall of 2008, the U.S. financial system, and financial systems around the world, appeared to be on the verge of collapse. Troubles in the financial sector spread to other industries, and a severe global recession ensued. In this section, we outline some of the main causes and consequences of that crisis.

FINANCIAL INSTITUTIONS AND REAL ESTATE FINANCE In the classic film It’s a Wonderful Life, the central character is George Bailey, who runs a financial institution called the Bailey Building and Loan Association. In a key scene in that movie, a bank run is about to occur and depositors demand that George return the money that they invested in the Building and Loan. George pleads with one man to keep his funds at the bank, saying: You’re thinking of this place all wrong, as if I have the money back in a safe. The money’s not here. Your money is in Joe’s house. That’s right next to yours—and then the Kennedy house, and Mrs. Maklin’s house, and a hundred others. You’re lending them the money to build, and then they’re going to pay it back to you as best they can. What are you going to do, foreclose on them?

securitization The process of pooling mortgages or other types of loans and then selling claims or securities against that pool in the secondary market.

mortgage-backed securities Securities that represent claims on the cash flows generated by a pool of mortgages.

This scene offers a relatively realistic portrayal of the role that financial institutions played in allocating credit for investments in residential real estate for many years. Local banks took deposits and made loans to local borrowers. However, since the 1970s, a process called securitization has changed the way that mortgage finance works. Securitization refers to the process of pooling mortgages or other types of loans and then selling claims or securities against that pool in a secondary market. These securities, called mortgage-backed securities, can be purchased by individual investors, pension funds, mutual funds, or virtually any other investor. As homeowners repay their loans, those payments eventually make their way into the hands of investors who hold the mortgage-backed securities. Therefore, a primary risk associated with mortgage-backed securities is that homeowners may not be able to, or may choose not to, repay their loans. Banks today still lend money to individuals who want to build or purchase new homes, but they typically bundle those loans together and sell them to organizations that securitize them and pass them on to investors all over the world.

FALLING HOME PRICES AND DELINQUENT MORTGAGES Prior to the 2008 financial crisis, most investors viewed mortgage-backed securities as relatively safe investments. Figure 2.2 on page 42 illustrates one of the main reasons for this view. The figure shows the behavior of the Standard & Poor’s Case-Shiller Index, a barometer of home prices in ten major U.S. cities, in each month from January 1987 to February 2010. Historically, declines in the index were relatively infrequent, and between July 1995 and April 2006 the index rose continuously without posting even a single monthly decline. When house prices are rising, the gap between what a borrower owes on a home and what the home is worth widens. Lenders will allow borrowers who have difficulty making payments on their mortgages to tap this built-up home equity to refinance their loans and lower their payments. Therefore, rising home prices helped keep mortgage default rates low from the mid-1990s through 2006. Investing in real estate and mortgage-backed securities seemed to involve very little risk during this period.

Introduction to Managerial Finance

FIGURE 2.2

250 200 150 20 10 Fe b.

100

19 87

Index Value

Housing Values Standard & Poor’s CaseShiller Home Price Index, January 1987 through February 2010

n.

PART 1

Ja

42

50 0

1987

’89

’91

’93

’95

’97 ’99 Time

’01

’03

’05

’07

2009

In part because real estate investments appeared to be relatively safe, lenders began relaxing their standards for borrowers. This led to tremendous growth in a category of loans called subprime mortgages. Subprime mortgages are mortgage loans made to borrowers with lower incomes and poorer credit histories as compared to “prime” borrowers. Often, loans granted to subprime borrowers have adjustable, rather than fixed, interest rates. This makes subprime borrowers particularly vulnerable if interest rates rise, and many of these borrowers (and lenders) assumed that rising home prices would allow borrowers to refinance their loans if they had difficulties making payments. Partly through the growth of subprime mortgages, banks and other financial institutions gradually increased their investments in real estate loans. In the year 2000, real estate loans accounted for less than 40 percent of the total loan portfolios of large banks. By 2007, real estate loans grew to more than half of all loans made by large banks, and the fraction of these loans in the subprime category increased as well. Unfortunately, as Figure 2.2 shows, home prices fell almost without interruption from May 2006 through May 2009. Over that three-year period, home prices fell on average by more than 30 percent. Not surprisingly, when homeowners had difficulty making their mortgage payments, refinancing was no longer an option, and delinquency rates and foreclosures began to climb. By 2009, nearly 25 percent of subprime borrowers were behind schedule on their mortgage payments. Some borrowers, recognizing that the value of their homes was far less than the amount they owed on their mortgages, simply walked away from their homes and let lenders repossess them.

CRISIS OF CONFIDENCE IN BANKS With delinquency rates rising, the value of mortgage-backed securities began to fall, and so too did the fortunes of financial institutions that had invested heavily in real estate assets. In March 2008, the Federal Reserve provided financing for the acquisition (that is, the rescue) of Bear Stearns by JPMorgan Chase. Later that year, Lehman Brothers filed for bankruptcy. Throughout 2008 and 2009, the Federal Reserve, the Bush administration, and finally the Obama administration took unprecedented steps to try to shore up the banking sector and stimulate the economy, but these measures could not completely avert the crisis.

CHAPTER 2

FIGURE 2.3

43

350 300 Index Value

Bank Stock Values Standard & Poor’s Banking Index, January 1, 2008 through May 17, 2010

The Financial Market Environment

250 200 150 100 50 0 Jan. 1 2008

July 1 2008

Jan. 1 2009

July 1 2009

Jan. 1 2010

May 17 2010

Time

Figure 2.3 shows the behavior of the Standard & Poor’s Banking Index, an index that tracks bank stocks. Bank stocks fell 81 percent between January 2008 and March 2009, and the number of bank failures skyrocketed. According to the Federal Deposit Insurance Corporation (FDIC), only three banks failed in 2007. In 2008 that number rose by a factor of eight to 25 failed banks, and the number increased nearly six times to 140 failures in 2009. While the economy began to recover in 2010, bank failures continued at a rapid pace, with 139 institutions failing in the first 10 months of that year.

SPILLOVER EFFECTS AND THE GREAT RECESSION As banks came under intense financial pressure in 2008, they began to tighten their lending standards and dramatically reduced the quantity of loans they made. In the aftermath of the Lehman Brothers bankruptcy, lending in the money market contracted very sharply. Corporations who had relied on the money market as a source of short-term funding found that they could no longer raise money in this market or could do so only at extraordinarily high rates. As a consequence, businesses began to hoard cash and cut back on expenditures, and economic activity contracted. Gross domestic product (GDP) declined in five out of six quarters starting in the first quarter of 2008, and the economy shed more than 8 million jobs in 2008–2009 as the unemployment rate reached 10 percent. Congress passed an $862 billion stimulus package to try to revive the economy, and the Federal Reserve pushed short-term interest rates close to 0 percent. By late 2009 and early 2010, there were signs that a gradual economic recovery had begun, but the job market remained stagnant, and most forecasts called for anemic economic growth. Perhaps the most important lesson from this episode is how important financial institutions are to a modern economy. By some measures, the 2008–2009 recession was the worst experienced in the United States since the Great Depression. Indeed, there many parallels between those two economic contractions. Both were preceded by a period of rapid economic growth, rising stock prices, and movements by banks into new lines of business, and both involved a

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major crisis in the financial sector. Recessions associated with a banking crisis tend to be more severe than other recessions because so many businesses rely on credit to operate. When financial institutions contract borrowing, activity in most other industries slows down too. 6

REVIEW QUESTIONS 2–8 What is securitization, and how does it facilitate investment in real

estate assets? 2–9 What is a mortgage-backed security? What is the basic risk associated

with mortgage-backed securities? 2–10 How do rising home prices contribute to low mortgage delinquencies? 2–11 Why do falling home prices create an incentive for homeowners to

default on their mortgages even if they can afford to make the monthly payments? 2–12 Why does a crisis in the financial sector spill over into other industries?

LG 5

2.3 Regulation of Financial Institutions and Markets The previous section discussed just how vulnerable modern economies are when financial institutions are in a state of crisis. Partly to avoid these types of problems, governments typically regulate financial institutions and markets as much or more than almost any other sector in the economy. This section provides an overview of the financial regulatory landscape in the United States.

REGULATIONS GOVERNING FINANCIAL INSTITUTIONS As mentioned in the previous section, Congress passed the Glass-Steagall Act in 1933 during the depths of the Great Depression. The early 1930s witnessed a series of banking panics that caused almost one-third of the nation’s banks to fail. Troubles within the banking sector and other factors contributed to the worst economic contraction in U.S. history, in which industrial production fell by more than 50 percent, the unemployment rate peaked at almost 25 percent, and stock prices dropped roughly 86 percent. The Glass-Steagall Act attempted to calm the public’s fears about the banking industry by establishing the Federal Deposit Federal Deposit Insurance Corporation (FDIC) Insurance Corporation (FDIC), which provided deposit insurance, effectively An agency created by the guaranteeing that individuals would not lose their money if they held it in a bank Glass-Steagall Act that that failed. The FDIC was also charged with examining banks on a regular basis provides insurance for deposits to ensure that they were “safe and sound.” The Glass-Steagall Act also prohibited at banks and monitors banks to institutions that took deposits from engaging in activities such as securities ensure their safety and underwriting and trading, thereby effectively separating commercial banks from soundness. investment banks. Over time, U.S. financial institutions faced competitive pressures from both domestic and foreign businesses that engaged in facilitating loans or making

CHAPTER 2

Gramm-Leach-Bliley Act An act that allows business combinations (that is, mergers) between commercial banks, investment banks, and insurance companies, and thus permits these institutions to compete in markets that prior regulations prohibited them from entering.

The Financial Market Environment

45

loans directly. Because these competitors either did not accept deposits or were located outside the United States, they were not subject to the same regulations as domestic banks. As a result, domestic banks began to lose market share in their core businesses. Pressure mounted to repeal the Glass-Steagall Act to enable U.S. banks to compete more effectively, and in 1999 Congress enacted and President Clinton signed the Gramm-Leach-Bliley Act, which allows commercial banks, investment banks, and insurance companies to consolidate and compete for business in a wider range of activities. In the aftermath of the recent financial crisis and recession, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010. In print, the new law runs for hundreds of pages and calls for the creation of several new agencies including the Financial Stability Oversight Council, the Office of Financial Research, and the Bureau of Consumer Financial Protection. The act also realigns the duties of several existing agencies and requires existing and new agencies to report to Congress regularly. As this book was going to press, the various agencies affected or created by the new law were writing rules specifying how the new law’s provisions would be implemented, so exactly how the new legislation will affect financial institutions and markets remains unclear.

REGULATIONS GOVERNING FINANCIAL MARKETS Securities Act of 1933 An act that regulates the sale of securities to the public via the primary market.

Securities Exchange Act of 1934 An act that regulates the trading of securities such as stocks and bonds in the secondary market.

Securities and Exchange Commission (SEC) The primary government agency responsible for enforcing federal securities laws.

Two other pieces of legislation were passed during the Great Depression that had an enormous impact on the regulation of financial markets. The Securities Act of 1933 imposed new regulations governing the sale of new securities. That is, the 1933 act was intended to regulate activity in the primary market in which securities are initially issued to the public. The act was designed to insure that the sellers of new securities provided extensive disclosures to the potential buyers of those securities. The Securities Exchange Act of 1934 regulates the secondary trading of securities such as stocks and bonds. The Securities Exchange Act of 1934 also created the Securities and Exchange Commission (SEC), which is the primary agency responsible for enforcing federal securities laws. In addition to the one-time disclosures required of security issuers by the Securities Act of 1933, the Securities Exchange Act of 1934 requires ongoing disclosure by companies whose securities trade in secondary markets. Companies must make a 10-Q filing every quarter and a 10-K filing annually. The 10-Q and 10-K forms contain detailed information about the financial performance of the firm during the relevant period. Today, these forms are available online through the SEC’s website known as EDGAR (Electronic Data Gathering, Analysis, and Retrieval). The 1934 act also imposes limits on the extent to which corporate “insiders,” such as senior managers, can trade in their firm’s securities. 6

REVIEW QUESTIONS 2–13 Why do you think so many pieces of important legislation related to

financial markets and institutions were passed during the Great Depression? 2–14 What different aspects of financial markets do the Securities Act of 1933 and the Securities Exchange Act of 1934 regulate?

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Introduction to Managerial Finance

PART 1

LG 6

2.4 Business Taxes Taxes are a fact of life, and businesses, like individuals, must pay taxes on income. The income of sole proprietorships and partnerships is taxed as the income of the individual owners; corporate income is subject to corporate taxes. Regardless of their legal form, all businesses can earn two types of income, ordinary and capital gains. Under current law, these two types of income are treated differently in the taxation of individuals; they are not treated differently for entities subject to corporate taxes. However, frequent amendments are made to the tax code, particularly as economic conditions change and when party control of the legislative and executive branches of government shifts.

ORDINARY INCOME ordinary income

The ordinary income of a corporation is income earned through the sale of goods or services. Ordinary income in 2010 was taxed subject to the rates depicted in the corporate tax rate schedule in Table 2.1.

Income earned through the sale of a firm’s goods or services.

Example

2.2

3

Webster Manufacturing, Inc., a small manufacturer of kitchen knives, has beforetax earnings of $250,000. The tax on these earnings can be found by using the tax rate schedule in Table 2.1: Total taxes due = $22,250 + 30.39 * ($250,000 - $100,000)4 = $22,250 + (0.39 * $150,000) = $22,250 + $58,500 = $80,750 From a financial point of view, it is important to understand the difference between average and marginal tax rates, the treatment of interest and dividend income, and the effects of tax deductibility.

marginal tax rate The rate at which additional income is taxed.

Marginal versus Average Tax Rates

The marginal tax rate represents the rate at which the next dollar of income is taxed. In the current corporate tax structure, the marginal tax rate is 15 percent

TA B L E 2 . 1

Corporate Tax Rate Schedule Tax calculation

Range of taxable income $

0 to $ 50,000 to

Base tax



(Marginal rate : amount over base bracket)

0

+

(15%

*

amount over

75,000

7,500

+

(25

*

amount over

50,000

$

$

0) 50,000)

75,000 to

100,000

13,750

+

(34

*

amount over

75,000)

100,000 to

335,000

22,250

+

(39

*

amount over

100,000)

335,000 to

10,000,000

113,900

+

(34

*

amount over

335,000)

10,000,000 to

15,000,000

3,400,000

+

(35

*

amount over

10,000,000)

15,000,000 to

18,333,333

5,150,000

+

(38

*

amount over

15,000,000)

6,416,667

+

(35

*

amount over

18,333,333)

Over 18,333,333

CHAPTER 2

The Financial Market Environment

47

if the firm earns less than $50,000. If a firm earns more than $50,000 but less than $75,000, the marginal tax rate is 25 percent. As a firm’s income rises, the marginal tax rate that it faces changes as shown in Table 2.1. In the example above, if Webster Manufacturing’s earnings increase to $250,001, the last $1 in income would be taxed at the marginal rate of 39 percent. The average tax rate paid on the firm’s ordinary income can be calculated by dividing its taxes by its taxable income. For most firms, the average tax rate does not equal the marginal tax rate because tax rates change with income levels. In the example above, Webster Manufacturing’s marginal tax rate is 39 percent, but its average tax rate is 32.3 percent ($80,750 , $250,000) . For very large corporations with earnings in the hundreds of millions or even billions of dollars, the average tax rate is very close to the 35 percent marginal rate in the top bracket because most of the firm’s income is taxed at that rate. In most of the business decisions that managers make, it’s the marginal tax rate that really matters. To keep matters simple, the examples in this text will use a flat 40 percent tax rate. That means that both the average tax rate and the marginal tax rate equal 40 percent.

average tax rate A firm’s taxes divided by its taxable income.

Interest and Dividend Income

double taxation Situation that occurs when after-tax corporate earnings are distributed as cash dividends to stockholders, who then must pay personal taxes on the dividend amount.

In the process of determining taxable income, any interest received by the corporation is included as ordinary income. Dividends, on the other hand, are treated differently. This different treatment moderates the effect of double taxation, which occurs when the already once-taxed earnings of a corporation are distributed as cash dividends to stockholders, who must pay taxes on dividends up to a maximum rate of 15 percent. Dividends that the firm receives on common and preferred stock held in other corporations are subject to a 70 percent exclusion for tax purposes.2 The dividend exclusion in effect eliminates most of the potential tax liability from the dividends received by the second and any subsequent corporations. Tax-Deductible Expenses

In calculating their taxes, corporations are allowed to deduct operating expenses, as well as interest expense. The tax deductibility of these expenses reduces their after-tax cost. The following example illustrates the benefit of tax deductibility.

Example

2.3

3

Two companies, Debt Co. and No-Debt Co., both expect in the coming year to have earnings before interest and taxes of $200,000. During the year, Debt Co. will have to pay $30,000 in interest. No-Debt Co. has no debt and therefore will

2. The 70 percent exclusion applies if the firm receiving dividends owns less than 20 percent of the shares of the firm paying the dividends. The exclusion is 80 percent if the corporation owns between 20 percent and 80 percent of the stock in the corporation paying it dividends; 100 percent of the dividends received are excluded if it owns more than 80 percent of the corporation paying it dividends. For convenience, we are assuming here that the ownership interest in the dividend-paying corporation is less than 20 percent.

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have no interest expense. Calculation of the earnings after taxes for these two firms is as follows: No-Debt Co.

$200,000

$200,000

30,000 $170,000

0 $200,000

68,000 $102,000

80,000 $120,000

i

Earnings before interest and taxes Less: Interest expense Earnings before taxes Less: Taxes (40%) Earnings after taxes

Debt Co.

Difference in earnings after taxes

$18,000

Debt Co. had $30,000 more interest expense than No-Debt Co., but Debt Co.’s earnings after taxes are only $18,000 less than those of No-Debt Co. This difference is attributable to the fact that Debt Co.’s $30,000 interest expense deduction provided a tax savings of $12,000 ($68,000 for Debt Co. versus $80,000 for No-Debt Co.). This amount can be calculated directly by multiplying the tax rate by the amount of interest expense (0.40 * $30,000 = $12,000). Similarly, the $18,000 after-tax cost of the interest expense can be calculated directly by multiplying 1 minus the tax rate by the amount of interest expense 3(1 - 0.40) * $30,000 = $18,0004. The tax deductibility of expenses reduces their actual (after-tax) cost to the firm as long as the firm is profitable. If a firm experiences a net loss in a given year, its tax liability is already zero. Even in this case, losses in one year can be used to offset taxes paid on profits in prior years, and in some cases losses can be “carried forward” to offset income and lower taxes in subsequent years. Note that both for accounting and tax purposes interest is a tax-deductible expense, whereas dividends are not. Because dividends are not tax deductible, their aftertax cost is equal to the amount of the dividend. Thus a $30,000 cash dividend has an after-tax cost of $30,000.

CAPITAL GAINS capital gain The amount by which the sale price of an asset exceeds the asset’s purchase price.

Example

2.4

3

If a firm sells a capital asset (such as stock held as an investment) for more than it paid for the asset, the difference between the sale price and purchase price is called a capital gain. For corporations, capital gains are added to ordinary corporate income and taxed at the regular corporate rates. Ross Company, a manufacturer of pharmaceuticals, has pretax operating earnings of $500,000 and has just sold for $150,000 an asset that was purchased 2 years ago for $125,000. Because the asset was sold for more than its initial purchase price, there is a capital gain of $25,000 ($150,000 sale price - $125,000 initial purchase price). The corporation’s taxable income will total $525,000 ($500,000 ordinary income plus $25,000 capital gain). Multiplying their taxable income by 40% produces Ross Company’s tax liability of $210,000.

CHAPTER 2

6

The Financial Market Environment

49

REVIEW QUESTIONS 2–15 Describe the tax treatment of ordinary income and that of capital gains.

What is the difference between the average tax rate and the marginal tax rate? 2–16 How does the tax treatment of dividend income by the corporation moderate the effects of double taxation? 2–17 What benefit results from the tax deductibility of certain corporate expenses?

Summary THE ROLE OF FINANCIAL INSTITUTIONS AND MARKETS Chapter 2 described why financial institutions and markets are an integral part of managerial finance. Companies cannot get started or survive without raising capital, and financial institutions and markets give firms access to the money they need to grow. As we have seen in recent years, however, financial markets can be quite turbulent, and when large financial institutions get into trouble, access to capital is reduced and firms throughout the economy suffer as a result. Taxes are an important part of this story as well because the rules governing how business income is taxed shape the incentives of firms to make new investments.

REVIEW OF LEARNING GOALS LG 1

Understand the role that financial institutions play in managerial finance. Financial institutions bring net suppliers of funds and net demanders together to help translate the savings of individuals, businesses, and governments into loans and other types of investments. The net suppliers of funds are generally individuals or households who save more money than they borrow. Businesses and governments are generally net demanders of funds, meaning that they borrow more money than they save. LG 2

Contrast the functions of financial institutions and financial markets. Both financial institutions and financial markets help businesses raise the money that they need to fund new investments for growth. Financial institutions collect the savings of individuals and channel those funds to borrowers such as businesses and governments. Financial markets provide a forum in which savers and borrowers can transact business directly. Businesses and governments issue debt and equity securities directly to the public in the primary market. Subsequent trading of these securities between investors occurs in the secondary market. LG 3

Describe the differences between the capital markets and the money markets. In the money market, savers who want a temporary place to deposit funds where they can earn interest interact with borrowers who have a shortterm need for funds. Marketable securities including Treasury bills, commercial paper, and other instruments are the primary securities traded in the money market. The Eurocurrency market is the international equivalent of the domestic money market.

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In contrast, the capital market is the forum in which savers and borrowers interact on a long-term basis. Firms issue either debt (bonds) or equity (stock) securities in the capital market. Once issued, these securities trade on secondary markets that are either broker markets or dealer markets. An important function of the capital market is to determine the underlying value of the securities issued by businesses. In an efficient market, the price of a security is an unbiased estimate of its true value. LG 4

Explain the root causes of the 2008 financial crisis and recession. The financial crisis was caused by several factors related to investments in real estate. Financial institutions lowered their standards for lending to prospective homeowners, and institutions also invested heavily in mortgage-backed securities. When home prices fell and mortgage delinquencies rose, the value of the mortgage-backed securities held by banks plummeted, causing some banks to fail and many others to restrict the flow of credit to business. That in turn contributed to a severe recession in the United States and abroad. LG 5

Understand the major regulations and regulatory bodies that affect financial institutions and markets. The Glass-Steagall Act created the FDIC and imposed a separation between commercial and investment banks. The act was designed to limit the risks that banks could take and to protect depositors. More recently, the Gramm-Leach-Bliley Act essentially repealed the elements of GlassSteagall pertaining to the separation of commercial and investment banks. After the recent financial crisis, much debate has occurred regarding the proper regulation of large financial institutions. The Securities Act of 1933 and the Securities Exchange Act of 1934 are the major pieces of legislation shaping the regulation of financial markets. The 1933 act focuses on regulating the sale of securities in the primary market, whereas the 1934 act deals with regulations governing transactions in the secondary market. The 1934 act also created the Securities and Exchange Commission, the primary body responsible for enforcing federal securities laws. LG 6

Discuss business taxes and their importance in financial decisions. Corporate income is subject to corporate taxes. Corporate tax rates apply to both ordinary income (after deduction of allowable expenses) and capital gains. The average tax rate paid by a corporation ranges from 15 to 35 percent. Corporate taxpayers can reduce their taxes through certain provisions in the tax code: dividend income exclusions and tax-deductible expenses. A capital gain occurs when an asset is sold for more than its initial purchase price; gains are added to ordinary corporate income and taxed at regular corporate tax rates. (For convenience, we assume a 40 percent marginal tax rate in this book.)

Opener-in-Review In the chapter opener you read about JPMorgan’s tumultuous ride through the 2008 financial crisis, and in the chapter itself you learned about capital market efficiency. What role do you think market efficiency (or inefficiency) played in the 10 percent fall of JPMorgan’s share price in a single day?

CHAPTER 2

Self-Test Problem LG 6

ST2–1

The Financial Market Environment

51

(Solution in Appendix)

Corporate taxes Montgomery Enterprises, Inc., had operating earnings of $280,000 for the year just ended. During the year the firm sold stock that it held in another company for $180,000, which was $30,000 above its original purchase price of $150,000, paid 1 year earlier. a. What is the amount, if any, of capital gains realized during the year? b. How much total taxable income did the firm earn during the year? c. Use the corporate tax rate schedule given in Table 2.1 to calculate the firm’s total taxes due. d. Calculate both the average tax rate and the marginal tax rate on the basis of your findings.

Warm-Up Exercises

All problems are available in

.

LG 1

E2–1

What does it mean to say that individuals as a group are net suppliers of funds for financial institutions? What do you think the consequences might be in financial markets if individuals consumed more of their incomes and thereby reduced the supply of funds available to financial institutions?

LG 2

E2–2

You are the chief financial officer (CFO) of Gaga Enterprises, an edgy fashion design firm. Your firm needs $10 million to expand production. How do you think the process of raising this money will vary if you raise it with the help of a financial institution versus raising it directly in the financial markets?

LG 3

E2–3

For what kinds of needs do you a think firm would issue securities in the money market versus the capital market?

LG 4

E2–4

Your broker calls to offer you the investment opportunity of a lifetime, the chance to invest in mortgage-backed securities. The broker explains that these securities are entitled to the principal and interest payments received from a pool of residential mortgages. List some of the questions you would ask your broker to assess the risk of this investment opportunity.

LG 6

E2–5

Reston, Inc., has asked your corporation, Pruro, Inc., for financial assistance. As a long-time customer of Reston, your firm has decided to give that assistance. The question you are debating is whether Pruro should take Reston stock with a 5% annual dividend or a promissory note paying 5% annual interest. Assuming payment is guaranteed and the dollar amounts for annual interest and dividend income are identical, which option will result in greater after-tax income for the first year?

Problems LG 6

All problems are available in P2–1

.

Corporate taxes Tantor Supply, Inc., is a small corporation acting as the exclusive distributor of a major line of sporting goods. During 2010 the firm earned $92,500 before taxes. a. Calculate the firm’s tax liability using the corporate tax rate schedule given in Table 2.1. b. How much are Tantor Supply’s 2010 after-tax earnings?

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Introduction to Managerial Finance

c. What was the firm’s average tax rate, based on your findings in part a? d. What is the firm’s marginal tax rate, based on your findings in part a? LG 6

P2–2

Average corporate tax rates Using the corporate tax rate schedule given in Table 2.1, perform the following: a. Calculate the tax liability, after-tax earnings, and average tax rates for the following levels of corporate earnings before taxes: $10,000; $80,000; $300,000; $500,000; $1.5 million; $10 million; and $20 million. b. Plot the average tax rates (measured on the y axis) against the pretax income levels (measured on the x axis). What generalization can be made concerning the relationship between these variables?

LG 6

P2–3

Marginal corporate tax rates Using the corporate tax rate schedule given in Table 2.1, perform the following: a. Find the marginal tax rate for the following levels of corporate earnings before taxes: $15,000; $60,000; $90,000; $200,000; $400,000; $1 million; and $20 million. b. Plot the marginal tax rates (measured on the y axis) against the pretax income levels (measured on the x axis). Explain the relationship between these variables.

LG 6

P2–4

Interest versus dividend income During the year just ended, Shering Distributors, Inc., had pretax earnings from operations of $490,000. In addition, during the year it received $20,000 in income from interest on bonds it held in Zig Manufacturing and received $20,000 in income from dividends on its 5% common stock holding in Tank Industries, Inc. Shering is in the 40% tax bracket and is eligible for a 70% dividend exclusion on its Tank Industries stock. a. Calculate the firm’s tax on its operating earnings only. b. Find the tax and the after-tax amount attributable to the interest income from Zig Manufacturing bonds. c. Find the tax and the after-tax amount attributable to the dividend income from the Tank Industries, Inc., common stock. d. Compare, contrast, and discuss the after-tax amounts resulting from the interest income and dividend income calculated in parts b and c. e. What is the firm’s total tax liability for the year?

LG 6

P2–5

Interest versus dividend expense Michaels Corporation expects earnings before interest and taxes to be $40,000 for the current period. Assuming an ordinary tax rate of 40%, compute the firm’s earnings after taxes and earnings available for common stockholders (earnings after taxes and preferred stock dividends, if any) under the following conditions: a. The firm pays $10,000 in interest. b. The firm pays $10,000 in preferred stock dividends.

LG 6

P2–6

Capital gains taxes Perkins Manufacturing is considering the sale of two nondepreciable assets, X and Y. Asset X was purchased for $2,000 and will be sold today for $2,250. Asset Y was purchased for $30,000 and will be sold today for $35,000. The firm is subject to a 40% tax rate on capital gains. a. Calculate the amount of capital gain, if any, realized on each of the assets. b. Calculate the tax on the sale of each asset.

LG 6

P2–7

Capital gains taxes The following table contains purchase and sale prices for the nondepreciable capital assets of a major corporation. The firm paid taxes of 40% on capital gains.

CHAPTER 2

The Financial Market Environment

Asset

Purchase price

Sale price

A B C D E

$ 3,000 12,000 62,000 41,000 16,500

$ 3,400 12,000 80,000 45,000 18,000

53

a. Determine the amount of capital gain realized on each of the five assets. b. Calculate the amount of tax paid on each of the assets. LG 5

P2–8

ETHICS PROBLEM The Securities Exchange Act of 1934 limits, but does not prohibit, corporate insiders from trading in their own firm’s shares. What ethical issues might arise when a corporate insider wants to buy or sell shares in the firm where he or she works?

Spreadsheet Exercise Hemingway Corporation is considering expanding its operations to boost its income, but before making a final decision they have asked you to calculate the corporate tax consequences of their decision. Currently Hemingway generates before-tax yearly income of $200,000 and has no debt outstanding. Expanding operations would allow Hemingway to increase before-tax yearly income to $350,000. Hemingway can use either cash reserves or debt to finance its expansion. If Hemingway uses debt, it will have yearly interest expense of $70,000.

TO DO Create a spreadsheet to conduct a tax analysis for Hemingway Corporation and determine the following: a. What is Hemingway’s current annual corporate tax liability? b. What is Hemingway’s current average tax rate? c. If Hemingway finances its expansion using cash reserves, what will be its new corporate tax liability and average tax rate? d. If Hemingway finances its expansion using debt, what will be its new corporate tax liability and average tax rate? e. What would you recommend that the firm do? Why? Visit www.myfinancelab.com for Chapter Case: The Pros and Cons of Being Publicly Listed, Group Exercises, and numerous online resources.

Integrative Case 1 Merit Enterprise Corp. ara Lehn, chief financial officer of Merit Enterprise Corp., was reviewing her presentation one last time before her upcoming meeting with the board of directors. Merit’s business had been brisk for the last two years, and the company’s CEO was pushing for a dramatic expansion of Merit’s production capacity. Executing the CEO’s plans would require $4 billion in capital in addition to $2 billion in excess cash that the firm had built up. Sara’s immediate task was to brief the board on options for raising the needed $4 billion. Unlike most companies its size, Merit had maintained its status as a private company, financing its growth by reinvesting profits and, when necessary, borrowing from banks. Whether Merit could follow that same strategy to raise the $4 billion necessary to expand at the pace envisioned by the firm’s CEO was uncertain, though it seemed unlikely to Sara. She had identified two options for the board to consider: Option 1: Merit could approach JPMorgan Chase, a bank that had served Merit well for many years with seasonal credit lines as well as medium-term loans. Lehn believed that JPMorgan was unlikely to make a $4 billion loan to Merit on its own, but it could probably gather a group of banks together to make a loan of this magnitude. However, the banks would undoubtedly demand that Merit limit further borrowing and provide JPMorgan with periodic financial disclosures so that they could monitor Merit’s financial condition as it expanded its operations. Option 2: Merit could convert to public ownership, issuing stock to the public in the primary market. With Merit’s excellent financial performance in recent years, Sara thought that its stock could command a high price in the market and that many investors would want to participate in any stock offering that Merit conducted. Becoming a public company would also allow Merit, for the first time, to offer employees compensation in the form of stock or stock options, thereby creating stronger incentives for employees to help the firm succeed. On the other hand, Sara knew that public companies faced extensive disclosure requirements and other regulations that Merit had never had to confront as a private firm. Furthermore, with stock trading in the secondary market, who knew what kind of individuals or institutions might wind up holding a large chunk of Merit stock?

S

TO DO a. Discuss the pros and cons of option 1, and prioritize your thoughts. What are the most positive aspects of this option, and what are the biggest drawbacks? b. Do the same for option 2. c. Which option do you think Sara should recommend to the board and why?

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Part

2

Financial Tools

Chapters in This Part

3 4 5

Financial Statements and Ratio Analysis Cash Flow and Financial Planning Time Value of Money INTEGRATIVE CASE 2 Track Software, Inc.

n Part 2 you will learn about some of the basic analytical tools that financial managers use almost every day. Chapter 3 reviews the main financial statements that are the primary means by which firms communicate with investors, analysts, and the rest of the business community. Chapter 3 also illustrates some simple tools that managers use to analyze the information contained in financial statements to identify and diagnose financial problems.

I

Firms create financial statements using the accrual principles of accounting, but in finance it is cash flow that really matters. Chapter 4 shows how to use financial statements to determine how much cash flow a firm is generating and how it is spending that cash flow. Chapter 4 also explains how firms develop short-term and long-term financial plans. Managers have to decide whether the up-front costs of investments are justified by the subsequent cash that those investments are likely to produce. Chapter 5 illustrates techniques that firms use to evaluate these sorts of trade-offs.

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3

Financial Statements and Ratio Analysis

Learning Goals

Why This Chapter Matters to You

LG 1 Review the contents of the

In your professional life

LG 2 Understand who uses financial

ACCOUNTING You need to understand the stockholders’ report and preparation of the four key financial statements; how firms consolidate international financial statements; and how to calculate and interpret financial ratios for decision making.

stockholders’ report and the procedures for consolidating international financial statements. ratios and how.

LG 3 Use ratios to analyze a firm’s

liquidity and activity.

LG 4 Discuss the relationship between

debt and financial leverage and the ratios used to analyze a firm’s debt.

LG 5 Use ratios to analyze a firm’s

profitability and its market value.

LG 6 Use a summary of financial ratios

and the DuPont system of analysis to perform a complete ratio analysis.

INFORMATION SYSTEMS You need to understand what data are included in the firm’s financial statements to design systems that will supply such data to those who prepare the statements and to those in the firm who use the data for ratio calculations. MANAGEMENT You need to understand what parties are interested in the stockholders’ report and why; how the financial statements will be analyzed by those both inside and outside the firm to assess various aspects of performance; the caution that should be exercised in using financial ratio analysis; and how the financial statements affect the value of the firm. MARKETING You need to understand the effects your decisions will have on the financial statements, particularly the income statement and the statement of cash flows, and how analysis of ratios, especially those involving sales figures, will affect the firm’s decisions about levels of inventory, credit policies, and pricing decisions. OPERATIONS You need to understand how the costs of operations are reflected in the firm’s financial statements and how analysis of ratios, particularly those involving assets, cost of goods sold, or inventory, may affect requests for new equipment or facilities. A routine step in personal financial planning is to prepare and analyze personal financial statements, so that you can monitor progress toward your financial goals. Also, you need to understand and analyze corporate financial statements to build and monitor your investment portfolio.

In your personal life

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Abercrombie & Fitch The Value of Casual Luxury

A

May 15, 2010, post on an investment website, Motley Fool, provided a valuation analysis for

clothing retailer Abercrombie & Fitch. Abercrombie’s stock price had been trending down for several weeks, and given that recent months had only just seen the end of one of the worst recessions in two generations, Motley Fool analysts did not expect the firm’s financial condition to be particularly impressive. However, they noted that Abercrombie’s current ratio was a healthy 2.79, and its quick ratio was also strong at 1.79. Furthermore, analysts noted that Abercrombie’s receivables collection period had quickened to 43 days in the prior year, and they concluded their report with a relatively positive outlook for the stock. Just a few days later, Abercrombie & Fitch announced that it would scale back planned overseas store openings, the markets where it had been enjoying the most rapid growth. In addition, the company reported that its gross profit margin declined in the most recent quarter. Markets responded to this information by sending Abercrombie stock down 7 percent on that day. Valuing the shares of a company is a difficult task. Analysts try to simplify that task by drawing data from financial reports produced by the company and calculating a variety of financial ratios using those data. These ratios help analysts answer questions such as, Does the firm have enough liquidity to pay the bills that will come due in the short term? and, How effectively does the firm collect cash from its customers? In this chapter, you will learn about the main financial statements that analysts rely on for this type of analysis, and you will see how information from those statements can be used to assess the overall performance of a company.

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PART 2

LG 1

Financial Tools

3.1 The Stockholders’ Report

generally accepted accounting principles (GAAP) The practice and procedure guidelines used to prepare and maintain financial records and reports; authorized by the Financial Accounting Standards Board (FASB).

Financial Accounting Standards Board (FASB) The accounting profession’s rule-setting body, which authorizes generally accepted accounting principles (GAAP).

Public Company Accounting Oversight Board (PCAOB) A not-for-profit corporation established by the SarbanesOxley Act of 2002 to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports.

Every corporation has many and varied uses for the standardized records and reports of its financial activities. Periodically, reports must be prepared for regulators, creditors (lenders), owners, and management. The guidelines used to prepare and maintain financial records and reports are known as generally accepted accounting principles (GAAP). These accounting practices and procedures are authorized by the accounting profession’s rule-setting body, the Financial Accounting Standards Board (FASB). In addition, the Sarbanes-Oxley Act of 2002, enacted in an effort to eliminate the many disclosure and conflict-of-interest problems of corporations, established the Public Company Accounting Oversight Board (PCAOB), a not-for-profit corporation that oversees auditors of public corporations. The PCAOB is charged with protecting the interests of investors and furthering the public interest in the preparation of informative, fair, and independent audit reports. The expectation is that it will instill confidence in investors with regard to the accuracy of the audited financial statements of public companies. Publicly owned corporations with more than $5 million in assets and 500 or more stockholders are required by the Securities and Exchange Commission (SEC)—the federal regulatory body that governs the sale and listing of securities— to provide their stockholders with an annual stockholders’ report. The stockholders’ report summarizes and documents the firm’s financial activities during the past year. It begins with a letter to the stockholders from the firm’s president and/or chairman of the board.

THE LETTER TO STOCKHOLDERS The letter to stockholders is the primary communication from management. It describes the events that are considered to have had the greatest effect on the firm

GLOBAL focus More Countries Adopt International Financial Reporting Standards in practice In the United States,

public companies are required to report financial results using GAAP. However, accounting standards vary around the world, and that makes comparing the financial results of firms located in different countries quite challenging. In recent years, many countries have adopted a system of accounting principles known as International Financial Reporting Standards (IFRS), which are established by an independent standards-setting body known as the International Accounting Standards

Board (IASB). These standards are designed with the goal of making financial statements everywhere understandable, reliable, comparable, and accurate. More than 80 countries now require listed firms to comply with IFRS, and dozens more permit or require firms to follow IFRS to some degree. Why hasn’t the United States followed the global trend of IFRS adoption? Some argue that GAAP is still the “gold standard,” and a movement to IFRS would lower the overall quality of financial reporting made by U.S. firms.

It is true that IFRS generally requires less detail than GAAP. Even so, the Securities and Exchange Commission has expressed its view that U.S. investors will benefit as GAAP and IFRS converge though there is no expectation that firms in the United States will be required to switch to IFRS in the near future. 3 What costs and benefits might be associated with a switch to IFRS in the United States?

CHAPTER 3

stockholders’ report Annual report that publicly owned corporations must provide to stockholders; it summarizes and documents the firm’s financial activities during the past year.

letter to stockholders Typically, the first element of the annual stockholders’ report and the primary communication from management.

income statement Provides a financial summary of the firm’s operating results during a specified period.

Financial Statements and Ratio Analysis

59

during the year. It also typically discusses management philosophy, corporate governance issues, strategies, and actions, as well as plans for the coming year.

THE FOUR KEY FINANCIAL STATEMENTS The four key financial statements required by the SEC for reporting to shareholders are (1) the income statement, (2) the balance sheet, (3) the statement of stockholders’ equity, and (4) the statement of cash flows. The financial statements from the 2012 stockholders’ report of Bartlett Company, a manufacturer of metal fasteners, are presented and briefly discussed in this section. Most likely, you have studied these four financial statements in an accounting course, so the purpose of looking at them here is to refresh your memory of the basics, rather than provide an exhaustive review. Income Statement

The income statement provides a financial summary of the firm’s operating results during a specified period. Most common are income statements covering a 1-year period ending at a specified date, ordinarily December 31 of the calendar year.

focus on ETHICS Taking Earnings Reports at Face Value in practice Near the end of each

quarter, Wall Street’s much anticipated “earnings season” arrives. During earnings season, many companies unveil their quarterly performance. Interest is high, as media outlets rush to report the latest announcements, analysts slice and dice the numbers, and investors buy and sell based on the news. The most anticipated performance metric for most companies is earnings per share (EPS), which is typically compared to the estimates of the analysts that cover a firm. Firms that beat analyst estimates often see their share prices jump, while those that miss estimates, by even a small amount, tend to suffer price declines. Many investors are aware of the pitfalls of judging firms based on reported earnings. Specifically, the complexity of financial reports makes it easy for managers to mislead investors. Sometimes, the methods used to mislead investors are within the rules, a

www.berkshirehathaway.com/letters/2002pdf.pdf

albeit not the spirit, of acceptable accounting practices. Other times, firms break the rules to make their numbers. The practice of manipulating earnings to mislead investors is known as earnings management. Some firms are notorious for consistently beating analysts’ estimates. For example, for one 10-year period (1995–2004), General Electric Co. (GE) beat Wall Street earnings estimates every quarter, often by only a penny or two per share. However, in 2009, the U.S. Securities and Exchange Commission (SEC) fined GE $50 million for improper accounting practices, including recording sales that had not yet occurred. When GE went back to correct the problems identified by the SEC, they found that net earnings between 2001 and 2007 were a total of $280 million lower than originally reported. In one of his famous letters to the shareholders of Berskshire Hathaway,

Warren Buffett offers three bits of advice regarding financial reporting.a First, he warns that weak visible accounting practices are typically a sign of bigger problems. Second, he suggests that, when you can’t understand management, the reason is probably that management doesn’t want you to understand them. Third, he warns that investors should be suspicious of projections because earnings and growth do not typically progress in an orderly fashion. Finally, Buffett notes that “Managers that always promise to ‘make the numbers’ will at some point be tempted to make up the numbers.” 3 Why might financial managers be tempted to manage earnings? 3 Is it unethical for managers to manage earnings if they disclose their activities to investors?

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PART 2

Financial Tools

Many large firms, however, operate on a 12-month financial cycle, or fiscal year, that ends at a time other than December 31. In addition, monthly income statements are typically prepared for use by management, and quarterly statements must be made available to the stockholders of publicly owned corporations. Table 3.1 presents Bartlett Company’s income statements for the years ended December 31, 2012 and 2011. The 2012 statement begins with sales revenue— the total dollar amount of sales during the period—from which the cost of goods sold is deducted. The resulting gross profit of $986,000 represents the amount remaining to satisfy operating, financial, and tax costs. Next, operating expenses, which include selling expense, general and administrative expense, lease expense, and depreciation expense, are deducted from gross profits. The resulting operating profits of $418,000 represent the profits earned from producing and selling products; this amount does not consider financial and tax costs. (Operating profit is often called earnings before interest and taxes, or EBIT.) Next, the financial cost—interest expense—is subtracted from operating profits