FINANCIAL
MANAGEMENT
GLOBAL
EDITION
Principles and Applications
FOURTEENTH
GLOBAL EDITION
Sheridan Titman
Arthur J. Keown
John D. Martin
Financial Management
Principles and Applications
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Fourteenth Global Edition
Financial Management
Principles and Applications
She rid a n Tit ma n
University of Texas at Austin
Walter W. McAllister Centennial Chair in Financial Services
Ar t hur J . Ke own
Virginia Polytechnic Institute and State University
Alumni Distinguished Professor and R. B. Pamplin Professor of Finance
J ohn D. Ma r t in
Baylor University
Carr P. Collins Chair in Finance
Harlow, England • London • New York • Boston • San Francisco • Toronto • Sydney • Dubai • Singapore • Hong Kong
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Authorized adaptation from the United States edition, entitled Financial Management: Principles and Applications,13th edition, ISBN 978-0-13441721-9, by Sheridan Titman, Arthur J. Keown, and John D. Martin published by Pearson Education © 2018.
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ISBN 10: 1-292-34982-4
ISBN 13: 978-1-292-34982-4
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The fourteenth Global Edition edition of Financial Management: Principles and
Applications is dedicated to our families—the ones who love us the most.
To my parents, wife (Meg), and sons (Trevor, Elliot, and Gordon)
Sheridan Titman
Barb, Emily, and Artie
Arthur J. Keown
To the Martin women (my wife, Sally, and daughter-in-law Mel), men (sons David and Jess), and
boys (grandsons Luke and Burke)
John D. Martin
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Brief
Contents
Preface
22
Part 1: Introduction to Financial Management
CHAPTER
1
Getting Started—Principles of Finance 34
CHAPTER
2
Firms and the Financial Markets 50
CHAPTER
3
Understanding Financial Statements 70
CHAPTER
4
Financial Analysis—Sizing Up Firm Performance 110
Part 2: Valuation of Financial Assets
CHAPTER
5
The Time Value of Money—The Basics 160
CHAPTER
6
The Time Value of Money—Annuities
and Other Topics 190
CHAPTER
7
An Introduction to Risk and Return—History of Financial
Market Returns 224
CHAPTER
8
Risk and Return—Capital Market Theory 254
CHAPTER
9
Debt Valuation and Interest Rates 286
CHAPTER
10
Stock Valuation 332
6
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BRIEF CONTENTS | 7
Part 3: Capital Budgeting
CHAPTER
11
Investment Decision Criteria 360
CHAPTER
12
Analyzing Project Cash Flows 404
CHAPTER
13
Risk Analysis and Project Evaluation 440
CHAPTER
14
The Cost of Capital 476
Part 4: Capital Structure and Dividend Policy
CHAPTER
15
Capital Structure Policy 514
CHAPTER
16
Dividend and Share Repurchase Policy 558
Part 5: Liquidity Management and Special Topics
in Finance
CHAPTER
17
Financial Forecasting and Planning 584
CHAPTER
18
Working-Capital Management 608
CHAPTER
19
International Business Finance 638
CHAPTER
20
Corporate Risk Management 664
Appendices Available in MyLab Finance
Glossary 699
Indexes 707
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Contents
Preface
22
Part 1: Introduction to Financial Management
CHAPTER
1
Getting Started—Principles of Finance
P Principle 1: Money Has a Time Value
34
35
P Principle 2: There Is a Risk-Return Tradeoff
35
P Principle 3: Cash Flows Are the Source of Value
P Principle 4: Market Prices Reflect Information
P Principle 5: Individuals Respond to Incentives
35
35
35
1.1
Finance: An Overview 36
What Is Finance? 36
Why Study Finance? 36
1.2 Types of Business Organizations 37
Sole Proprietorship 38
Partnership 38
Corporation 38
Not for Profit Organization 39
Co-operative 40
How Does Finance Fit into the Firm’s Organizational Structure? 40
1.3 The Goal of the Financial Manager 41
Maximizing Shareholder Wealth 41
Ethical Considerations in Corporate Finance 42
Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley Act 43
1.4 The Five Basic Principles of Finance 43
Principle 1: Money Has a Time Value 43
Principle 2: There Is a Risk-Return Tradeoff 44
Principle 3: Cash Flows Are the Source of Value 44
Principle 4: Market Prices Reflect Information 45
Principle 5: Individuals Respond to Incentives 45
Chapter Summaries 47
Study Questions 49
CHAPTER
2
Firms and the Financial Markets 50
P Principle 2: There Is a Risk-Return Tradeoff
51
P Principle 4: Market Prices Reflect Information
51
P Principle 5: Individuals Respond to Incentives 51
2.1 The Basic Structure of Financial Markets 52
2.2 The Financial Marketplace: Financial Institutions 53
Commercial Banks: Everyone’s Financial Marketplace 54
Nonbank Financial Intermediaries 54
FINANCE FOR LIFE : Planning for Retirement 56
2.3 The Financial Marketplace: Securities Markets 57
How Securities Markets Bring Corporations and Investors Together 58
Types of Securities 59
FINANCE IN A FLAT WORLD: Where’s the Money Around the World
Chapter Summaries 66
Study Questions 68
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10
CONTENTS |
CHAPTER
3
Understanding Financial Statements 70
P Principle 1: Money Has a Time Value
71
P Principle 3: Cash Flows Are the Source of Value
71
P Principle 4: Market Prices Reflect Information 71
P Principle 5: Individuals Respond to Incentives 71
3.1 An Overview of the Firm’s Financial Statements 72
Basic Financial Statements 72
Why Study Financial Statements? 73
What Are the Accounting Principles Used to Prepare Financial Statements? 73
3.2 The Income Statement 74
Income Statement of H. J. Boswell, Inc. 74
Connecting the Income Statement and Balance Sheet 76
Interpreting Firm Profitability Using the Income Statement 76
GAAP and Earnings Management 77
3.3 Corporate Taxes 79
Computing Taxable Income 79
Federal Income Tax Rates for Corporate Income 79
Marginal and Average Tax Rates 80
Dividend Exclusion for Corporate Stockholders 80
3.4 The Balance Sheet 81
The Balance Sheet of H. J. Boswell, Inc. 81
Firm Liquidity and Net Working Capital 84
Debt and Equity Financing 85
Book Values, Historical Costs, and Market Values 87
FINANCE FOR LIFE : Preparing a Balance Sheet and an Income Statement
for a Business 88
3.5 The Cash Flow Statement 90
Sources and Uses of Cash 90
H. J. Boswell’s Cash Flow Statement 92
FINANCE IN A FLAT WORLD : GAAP vs. IFRS 93
Chapter Summaries 99
Study Questions 102
Study Problems 103
Mini-Case 107
CHAPTER
4
Financial Analysis—Sizing Up Firm Performance
110
P Principle 3: Cash Flows Are the Source of Value
111
111
P Principle 5: Individuals Respond to Incentives 111
4.1 Why Do We Analyze Financial Statements? 112
4.2 Common-Size Statements: Standardizing Financial Information
The Common-Size Income Statement: H. J. Boswell, Inc. 113
The Common-Size Balance Sheet: H. J. Boswell, Inc. 114
4.3 Using Financial Ratios 115
Liquidity Ratios 115
Capital Structure Ratios 121
Asset Management Efficiency Ratios 122
Profitability Ratios 126
Market Value Ratios 133
FINANCE FOR LIFE : Making That Big Purchase! 134
FINANCE IN A FLAT WORLD: Ratios and International
Accounting Standards 137
Summing Up the Financial Analysis of H. J. Boswell, Inc. 137
P Principle 4: Market Prices Reflect Information
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CONTENTS | 11
4.4
Selecting a Performance Benchmark
Trend Analysis 139
Peer-Firm Comparisons 140
4.5 Limitations of Ratio Analysis 141
Chapter Summaries 143
Study Questions 146
Study Problems 146
Mini-Case 159
139
Part 2: Valuation of Financial Assets
CHAPTER
5
The Time Value of Money—The Basics
160
P Principle 1: Money Has a Time Value
161
5.1 Using Timelines to Visualize Cash Flows 162
5.2 Compounding and Future Value 164
Compound Interest and Time 165
Compound Interest and the Interest Rate 165
Techniques for Moving Money Through Time 165
Applying Compounding to Things Other Than Money 167
Compound Interest with Shorter Compounding Periods 167
FINANCE FOR LIFE: Getting on the Property Ladder 171
5.3 Discounting and Present Value 171
The Mechanics of Discounting Future Cash Flows 172
Two Additional Types of Discounting Problems 174
The Rule of 72 175
5.4 Making Interest Rates Comparable 177
Calculating the Interest Rate and Converting It to an EAR 179
To the Extreme: Continuous Compounding 180
FINANCE IN A FLAT WORLD: Financial Access at Birth 181
Chapter Summaries 182
Study Questions 184
Study Problems 185
Mini-Case 189
CHAPTER
6
The Time Value of Money—Annuities and Other Topics 190
P Principle 1: Money Has a Time Value
191
P Principle 3: Cash Flows Are the Source of Value
191
Annuities 192
Ordinary Annuities 192
Amortized Loans 200
Annuities Due 201
FINANCE FOR LIFE: Saving for Retirement: Being an Early Bird
6.2 Perpetuities 205
Calculating the Present Value of a Level Perpetuity 205
Calculating the Present Value of a Growing Perpetuity 205
6.3 Complex Cash Flow Streams 208
Chapter Summaries 212
Study Questions 213
Study Problems 214
Mini-Case 223
6.1
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12
CONTENTS |
CHAPTER
7
An Introduction to Risk and Return—History of Financial
Market Returns 224
P Principle 2: There Is a Risk-Return Tradeoff
225
225
7.1 Realized and Expected Rates of Return and Risk 226
Calculating the Realized Return from an Investment 226
Calculating the Expected Return from an Investment 227
Measuring Risk 228
7.2 A Brief History of Financial Market Returns 234
U.S. Financial Markets: Domestic Investment Returns 234
Lessons Learned 236
U.S. Stocks Versus Other Categories of Investments 236
Global Financial Markets: International Investing 236
FINANCE FOR LIFE: Your Personal Financial Risk Tolerance 238
7.3 Geometric Versus Arithmetic Average Rates of Return 239
Computing the Geometric or Compound Average Rate of Return 239
Choosing the Right “Average” 240
7.4 What Determines Stock Prices? 243
The Efficient Markets Hypothesis 243
Do We Expect Financial Markets to Be Perfectly Efficient? 244
Market Efficiency: What Does the Evidence Show? 245
Chapter Summaries 247
Study Questions 250
Study Problems 250
Mini-Case 253
P Principle 4: Market Prices Reflect Information
CHAPTER
8
Risk and Return—Capital Market Theory
254
P Principle 2: There Is a Risk-Return Tradeoff
255
255
8.1 Portfolio Returns and Portfolio Risk 256
Calculating the Expected Return of a Portfolio 256
Evaluating Portfolio Risk 258
Calculating the Standard Deviation of a Portfolio’s Returns 260
FINANCE IN A FLAT WORLD: International Diversification
8.2 Systematic Risk and the Market Portfolio 265
Diversification and Unsystematic Risk 266
Diversification and Systematic Risk 267
Systematic Risk and Beta 267
Calculating the Portfolio Beta 269
8.3 The Security Market Line and the CAPM 270
Using the CAPM to Estimate Expected Rates of Return 272
Chapter Summaries 275
Study Questions 277
Study Problems 278
Mini-Case 285
P Principle 4: Market Prices Reflect Information
CHAPTER
263
9
Debt Valuation and Interest Rates 286
P Principle 1: Money Has a Time Value
287
P Principle 2: There Is a Risk-Return Tradeoff
287
P Principle 3: Cash Flows Are the Source of Value
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CONTENTS | 13
9.1
Overview of Corporate Debt 288
Borrowing Money in the Private Financial Market 288
Borrowing Money in the Public Financial Market 290
Basic Bond Features 293
FINANCE FOR LIFE: Buying a House in the United Kingdom 295
9.2 Valuing Corporate Debt 297
Valuing Bonds by Discounting Future Cash Flows 297
Step 1: Determine Bondholder Cash Flows 298
Step 2: Estimate the Appropriate Discount Rate 298
Step 3: Calculate the Present Value Using the Discounted Cash Flow 301
9.3 Bond Valuation: Four Key Relationships 305
Relationship 1 305
Relationship 2 307
Relationship 3 307
Relationship 4 308
9.4 Types of Bonds 310
Secured Versus Unsecured 310
Priority of Claims 310
Initial Offering Market 310
Abnormal Risk 310
Coupon Level 310
Amortizing or Non-amortizing 310
Convertibility 311
FINANCE IN A FLAT WORLD: International Bonds 312
9.5 Determinants of Interest Rates 312
Inflation and Real Versus Nominal Interest Rates 312
Interest Rate Determinants—Breaking It Down 314
The Maturity-Risk Premium and the Term Structure of Interest Rates 317
Chapter Summaries 322
Study Questions 326
Study Problems 327
Mini-Case 331
CHAPTER
10
Stock Valuation
332
P Principle 1: Money Has a Time Value
333
P Principle 2: There Is a Risk-Reward Tradeoff
333
333
P Principle 4: Market Prices Reflect Information 333
P Principle 5: Individuals Respond to Incentives 333
10.1 Common Stock 334
Characteristics of Common Stock 334
FINANCE FOR LIFE: Stock Valuation Practices: Scientific Methods or
Emotional Reactions 335
Agency Costs and Common Stock 336
Valuing Common Stock Using the Discounted Dividend Model 336
10.2 The Comparables Approach to Valuing Common Stock 343
Defining the P/E Ratio Valuation Model 343
What Determines the P/E Ratio for a Stock? 343
An Aside on Managing for Shareholder Value 347
A Word of Caution About P/E Ratios 347
10.3 Preferred Stock 347
Features of Preferred Stock 347
Valuing Preferred Stock 348
A Quick Review: Valuing Bonds, Preferred Stock, and Common Stock 350
P Principle 3: Cash Flows Are the Source of Value
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14
CONTENTS |
Chapter Summaries 353
Study Questions 355
Study Problems 356
Mini-Case 359
Part 3: Capital Budgeting
CHAPTER
11
Investment Decision Criteria 360
P Principle 1: Money Has a Time Value
361
P Principle 2: There Is a Risk-Return Tradeoff
361
P Principle 3: Cash Flows Are the Source of Value
P Principle 5: Individuals Respond to Incentives
361
361
11.1 An Overview of Capital Budgeting 362
The Typical Capital-Budgeting Process 363
What Are the Sources of Good Investment Projects? 363
Types of Capital Investment Projects 363
11.2 Net Present Value 364
Why Is the NPV the Right Criterion? 365
Calculating an Investment’s NPV 365
Independent Versus Mutually Exclusive Investment Projects 366
11.3 Other Investment Criteria 372
Profitability Index 372
Internal Rate of Return 374
Modified Internal Rate of Return 380
FINANCE FOR LIFE: Higher Education as an Investment in Yourself
Payback Period 384
Discounted Payback Period 385
Summing Up the Alternative Decision Rules 387
11.4 A Glance at Actual Capital-Budgeting Practices 387
Chapter Summaries 390
Study Questions 393
Study Problems 394
Mini-Cases 401
CHAPTER
384
12
Analyzing Project Cash Flows 404
P Principle 3: Cash Flows Are the Source of Value
P Principle 5: Individuals Respond to Incentives
405
405
12.1 Project Cash Flows 406
Incremental Cash Flows Are What Matters 407
Guidelines for Forecasting Incremental Cash Flows 407
12.2 Forecasting Project Cash Flows 409
Dealing with Depreciation Expense, Taxes, and Cash Flow 409
Four-Step Procedure for Calculating Project Cash Flows 410
Computing Project NPV 414
12.3 Inflation and Capital Budgeting 416
Estimating Nominal Cash Flows 416
12.4 Replacement Project Cash Flows 417
Category 1: Initial Outlay, CF0 417
Category 2: Annual Cash Flows 417
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CONTENTS | 15
Replacement Example 418
FINANCE IN A FLAT WORLD: Entering New Markets
Chapter Summaries 423
Study Questions 425
Study Problems 426
Mini-Cases 435
Appendix: The Modified Accelerated Cost Recovery System
CHAPTER
422
438
13
Risk Analysis and Project Evaluation 440
P Principle 1: Money Has a Time Value
441
P Principle 2: There Is a Risk-Return Tradeoff
441
P Principle 3: Cash Flows Are the Source of Value
441
13.1 The Importance of Risk Analysis 442
13.2 Tools for Analyzing the Risk of Project Cash Flows 443
Key Concepts: Expected Values and Value Drivers 443
Sensitivity Analysis 445
Scenario Analysis 449
Simulation Analysis 452
FINANCE IN A FLAT WORLD: Currency Risk 454
13.3 Break-Even Analysis 454
Accounting Break-Even Analysis 455
Cash Break-Even Analysis 459
NPV Break-Even Analysis 459
Operating Leverage and the Volatility of Project Cash Flows 462
13.4 Real Options in Capital Budgeting 464
The Option to Delay the Launch of a Project 464
The Option to Expand a Project 465
The Option to Reduce the Scale and Scope of a Project 465
Chapter Summaries 467
Study Questions 469
Study Problems 470
Mini-Case 475
CHAPTER
14
The Cost of Capital 476
P Principle 1: Money Has a Time Value
477
P Principle 2: There Is a Risk-Return Tradeoff
477
P Principle 3: Cash Flows Are the Source of Value
P Principle 4: Market Prices Reflect Information
P Principle 5: Individuals Respond to Incentives
477
477
477
14.1 The Cost of Capital: An Overview 478
Investor’s Required Return and the Firm’s Cost of Capital 479
WACC Equation 479
Three-Step Procedure for Estimating the Firm’s WACC 480
14.2 Determining the Firm’s Capital Structure Weights 481
14.3 Estimating the Cost of Individual Sources of Capital 485
The Cost of Debt 485
The Cost of Preferred Equity 486
The Cost of Common Equity 488
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16
CONTENTS |
14.4 Summing Up: Calculating the Firm’s WACC 495
Use Market-Based Weights 495
Use Market-Based Costs of Capital 495
Use Forward-Looking Weights and Opportunity Costs 495
Weighted Average Cost of Capital in Practice 495
14.5 Estimating Project Costs of Capital 497
The Rationale for Using Multiple Discount Rates 497
Why Don’t Firms Typically Use Project Costs of Capital? 497
Estimating Divisional WACCs 498
Divisional WACC: Estimation Issues and Limitations 499
FINANCE IN A FLAT WORLD: Why Do Interest Rates
Differ Among Countries? 500
14.6 Flotation Costs and Project NPV 501
WACC, Flotation Costs, and the NPV 501
Chapter Summaries 504
Study Questions 507
Study Problems 508
Mini-Case 512
Part 4: Capital Structure and Dividend Policy
CHAPTER
15
Capital Structure Policy
514
P Principle 2: There Is a Risk-Return Tradeoff
515
P Principle 3: Cash Flows Are the Source of Value
515
515
15.1 A Glance at Capital Structure Choices in Practice 516
Defining a Firm’s Capital Structure 516
Financial Leverage 519
How Do Firms in Different Industries Finance Their Assets? 519
15.2 Capital Structure Theory 520
A First Look at the Modigliani and Miller Capital Structure Theorem 520
Yogi Berra and the M&M Capital Structure Theory 522
Capital Structure, the Cost of Equity, and the Weighted Average Cost of Capital 522
Why Capital Structure Matters in Reality 524
Making Financing Choices When Managers Are Better Informed than Shareholders 529
Managerial Implications 530
15.3 Why Do Capital Structures Differ Across Industries? 531
15.4 Making Financing Decisions 532
Benchmarking the Firm’s Capital Structure 532
Evaluating the Effect of Financial Leverage on Firm Earnings per Share 533
Using the EBIT-EPS Chart to Analyze the Effect of Capital Structure on EPS 538
Can the Firm Afford More Debt? 540
Survey Evidence: Factors That Influence CFO Debt Policy 541
FINANCE IN A FLAT WORLD : Capital Structures Around the World 542
Lease Versus Buy 543
FINANCE FOR LIFE: Leasing or Buying a Car 545
Chapter Summaries 546
Study Questions 548
Study Problems 550
Mini-Case 554
Appendix: Demonstrating the Modigliani and Miller Theorem 555
P Principle 5: Individuals Respond to Incentives
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CONTENTS | 17
CHAPTER
16
Dividend and Share Repurchase Policy
P Principle 1: Money Has a Time Value
558
559
P Principle 3: Cash Flows Are the Source of Value
559
P Principle 4: Market Prices Reflect Information 559
16.1 How Do Firms Distribute Cash to Their Shareholders? 560
Cash Dividends 561
Stock Repurchases 562
How Do Firms Repurchase Their Shares? 562
Personal Tax Considerations: Dividend Versus Capital Gains Income 563
Noncash Distributions: Stock Dividends and Stock Splits 563
16.2 Does Dividend Policy Matter? 564
The Irrelevance of the Distribution Choice 564
Why Dividend Policy Is Important 570
FINANCE FOR LIFE: How Tax Policies Influence Dividend Distribution
16.3 Cash Distribution Policies in Practice 573
Stable Dividend Payout Policy 573
Residual Dividend Payout Policy 576
Other Factors Playing a Role in How Much to Distribute 576
Chapter Summaries 578
Study Questions 579
Study Problems 581
Mini-Case 583
573
Part 5: Liquidity Management and Special
Topics in Finance
CHAPTER
17
Financial Forecasting and Planning 584
P Principle 2: There Is a Risk-Return Tradeoff
585
17.1 An Overview of Financial Planning 586
17.2 Developing a Long-Term Financial Plan 587
Financial Forecasting Example: Ziegen, Inc. 588
FINANCE FOR LIFE: Your Personal Budget 593
17.3 Developing a Short-Term Financial Plan 596
Cash Budget Example: Melco Furniture, Inc. 596
Uses of the Cash Budget 597
Chapter Summaries 599
Study Questions 600
Study Problems 601
Mini-Case 607
CHAPTER
18
Working-Capital Management 608
P Principle 2: There Is a Risk-Return Tradeoff
609
18.1 Working-Capital Management and the Risk-Return Tradeoff 610
Measuring Firm Liquidity 610
Managing Firm Liquidity 611
Risk-Return Tradeoff 611
18.2 Working-Capital Policy 611
The Principle of Self-Liquidating Debt 611
A Graphic Illustration of the Principle of Self-Liquidating Debt 614
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CONTENTS |
18
18.3 Operating and Cash Conversion Cycles 614
Measuring Working-Capital Efficiency 614
Calculating the Operating and Cash Conversion Cycles 616
18.4 Managing Current Liabilities 619
Calculating the Cost of Short-Term Financing 619
Evaluating the Cost of Trade Credit 620
Evaluating the Cost of Bank Loans 621
18.5 Managing the Firm’s Investment in Current Assets 623
Managing Cash and Marketable Securities 623
Managing Accounts Receivable 625
FINANCE FOR LIFE: Your Credit Score 627
Managing Inventories 629
Chapter Summaries 630
Study Questions 632
Study Problems 633
Mini-Case 637
665
Corporate Risk Management 664
P Principle 2: There Is a Risk-Return Tradeoff
665
20.1 Five-Step Corporate Risk Management Process 666
Step 1: Identify and Understand the Firm’s Major Risks 666
Step 2: Decide Which Types of Risks to Keep and Which to Transfer 667
Step 3: Decide How Much Risk to Assume 667
Step 4: Incorporate Risk into All the Firm’s Decisions and Processes 667
Step 5: Monitor and Manage the Firm’s Risk Exposure 668
20.2 Managing Risk with Insurance Contracts 669
Types of Insurance Contracts 669
Why Purchase Insurance? 669
FINANCE FOR LIFE: Do You Need Life Insurance? 670
20.3 Managing Risk by Hedging with Forward Contracts 670
Hedging Commodity Price Risk Using Forward Contracts 671
Hedging Currency Risk Using Forward Contracts 671
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk R
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk R
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk R
sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk R
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sk Risk Risk Risk Risk Risk Risk Risk Risk Ris
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk
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k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
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k Risk Risk Risk Risk Risk Risk Risk Risk Risk Ris
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k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
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sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Ri
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sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk
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k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk R
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Ri
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Ris
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sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
isk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
sk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
k Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk Risk
P Principle 1: Money Has a Time Value
Risk Management
639
P Principle 2: There Is a Risk-Return Tradeoff
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A01_TITM9824_14_GE_FM.indd 18
20
CHAPTER
19
CHAPTER
International Business Finance 638
P Principle 3: Cash Flows Are the Source of Value
639
19.1 Foreign Exchange Markets and Currency Exchange Rates 640
What a Change in the Exchange Rate Means for Business 640
Foreign Exchange Rates 642
Types of Foreign Exchange Transactions 645
19.2 Interest Rate and Purchasing-Power Parity 648
Interest Rate Parity 648
Purchasing-Power Parity and the Law of One Price 648
The International Fisher Effect 649
19.3 Capital Budgeting for Direct Foreign Investment 651
FINANCE FOR LIFE: International Investing 652
Foreign Investment Risks 655
Chapter Summaries 657
Study Questions 659
Study Problems 660
Mini-Case 663
CONTENTS | 19
20.4 Managing Risk with Exchange-Traded Financial Derivatives
Futures Contracts 676
Option Contracts 677
20.5 Valuing Options and Swaps 683
The Black-Scholes Option Pricing Model 684
Swap Contracts 688
Credit Default Swaps 689
Chapter Summaries 691
Study Questions 693
Study Problems 694
Mini-Case 697
675
Appendices Available in MyLab Finance
Glossary 699
Indexes 707
A01_TITM9824_14_GE_FM.indd 19
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Teaching Students the
of Finance
The Five Principles of Finance
Many finance books show students only the mechanics of finance problem solving, but students learn
better when given the intuition behind complex concepts. Financial Management shows students the
reasoning behind financial decisions and connects all topics in the book to five key principles—the
Five Principles of Finance. P Principle 1, P Principle 2, P Principle 3, P Principle 4, P Principle 5
2, P 3,
P
4, and
P
5 Applied
ns that
1,
ncial decisio sonal
ge of fina
Principles
per
a wide ran as well as in their
k by
s
examines
This book in their business live tion for the entire boo nt
ere
nda
ke
diff
fou
ma
a
lay
nce, the
people
chapter, we
study of fina that the finanlives. In this boundaries of the
the role
and
e of
,
the
som
zed
ing
s
addres
describ
s are organi
. We also
businesse
e daily.
hin the firm
ways that
er must fac
er plays wit the financial manag
cial manag
as that
mm
dile
l
the ethica
P
P
of finance
principles
Has
at the five
le 1: Money
epth look
take an in-d decisions: P Princip eturn Tradeoff,
al
Finally, we
k-R
P Prine all financi le 2: There Is a Ris
erli
ue,
und
t
Val
tha
P Princip
Source of P Principle 5:
ue,
the
Val
e
Are
ws
a Tim
3: Cash Flo ect Information, and
P Principle
Refl
rket Prices
s.
ciple 4: Ma
to Incentive
s Respond
Individual
Each chapter opens with a helpful preview of those
Principles of Finance that are illustrated in the coming chapter so students see the underlying and connecting themes and learn to recognize patterns. Principles
are color-coded for quick recognition.
The chapter-opening vignette provides a
real-world example of the Principles
Finance applied in the chapter, many
times reinforcing them by showing how
“forgetting” a principle might lead to financial troubles.
Wolfsburg,
, based in
gen Group
its customthe Volkswa million vehicles to carmaker
ten
Every year
st
er
is the large
ment
delivers ov
ed brands,
Germany,
s, manage D
This group
businesse
ll-recogniz
the world.
R&
twelve we
tti, Lambo- a diverse portfolio of tial new products,
ers across
t
and owns ODA, Bentley, Buga
ate poten
run such
s will affec
alu
to
ion
ŠK
ev
in Europe
er
,
cis
ld
AT
ord
de
ou
Audi, SE
we may
g others. In ging decisions. It sh ilities. Each of these
e,
on
for
am
including
ere
ti
D fac
challen
rates. Th
he, Duca
ta
R&
of
ne
no
rsc
or
er
ge
d
Po
it
,
on
an
mb
ini
s
cti
sh
du
a nu
rgh
sines
of ca
faced with
of any bu
s to start pro ecting the amount
is regularly scour new location
egral part
aff
business,
d
nt is an int
ting the
projects, an and revenue of the Financial manageme
ether evalua or to
cost
s.
nal life. Wh
ion
rso
cis
pe
de
r
l
graduation
the future
ions in you
right after
as financia
e
cis
siderse
de
gre
l
con
de
the
cia
d
w
s an
vie
ster’s
n finan
function.
take certai ether to go to for a ma fundamental principle
standalone wagen, you have to
ighing wh
e the same
Like Volks
using or we find that these requir
ho
for
ns
will
nks loa
terms of ba for a year or two, you
s.
me
35
work full-ti ide business decision
gu
ations that
Applying the
Principles of
Finance to
Chapter 17
Principle 2: The
re Is a Risk
financial planning
process because -Return Tradeoff arises
alternate possible
planning enables
in the
requirements. By
levels of firm sales
the
being prepared,
and correspondingly firm to prepare for
the
and increases the
value of its comm firm reduces the risk to its share
different financing
holders
on stock.
P
599
C H A P
ummaries
17
The Summaries that conclude each chapter
review the Principles of Finance in context,
promoting deeper understanding and
greater retention of chapter concepts.
T E R
Chapter S
17.1 Unders
tand the goals
of financial pla
SUMMARY:
nning. (pgs. 586–
The goal of
587)
financial plan
use as a guid
ning is the dev
e to the futu
re.
elopment of
requirements
a plan that a
. However, fina Such a plan provides the
firm
firm with estim
that the firm
ncial planning
’s managem
ates of its fina can
has a second
ent team goe
and
is useful in itsel
ncing
mor
e subtle goal.
s through a
The very fact
careful and thou
firm’s managemf. That is, the very act of
ghtful planning
thin
exercise
valuable exer ent develop an understand king systematically abo
ut the future
cise.
ing of what
helps the
may happen
, and this is
KEY TERMS
in itself a
Concept Che
ck | 17.1
1. What are
the fund
benefits of finan amental
cial planning?
2. Distinguish
among a firm’s
short-term finan
cial plan,
long-term finan
cial plan, and
strategic plan.
Cash budget,
page 587
A plan for a futu
period that deta
re
ils the sources
ticipates rece
of cash a firm
iving and the
anamounts and
cash it plans to
timing of
spend.
Long-term fina
ncial plan, pag
detailed estim
e 587 A
ate of a firm’s
sources and uses
financing for
a period that
of
extends three
years into the
to five
future.
Short-term fina
forecast of a firm ncial plan, page 587
A
’s
uses of cash span sources of cash and plan
ned
ning the next
12 months or
less.
scription of the , page 586 A general defirm, its products
and how it plan
and services,
s to compete
with other firm
order to sell thos
s in
e products and
services.
Strategic plan
17.2 Use the
Within the chapter, the authors draw on the Five Principles of
Finance to illustrate concepts and explain the rationale behind
financial decision making. Look for P , P , P , P , P v
P Principle 1: Money Has a Time Value
P Principle 2: There Is a Risk-Return Tradeoff
P Principle 3: Cash Flows Are the Source of Value
P Principle 4: Market Prices Reflect Information
P Principle 5: Individuals Respond to Incentives
A01_TITM9824_14_GE_FM.indd 20
percent-of-sa
les method to
a firm, includ
forecast the
ing its
financing req
discretionary
SUMMARY:
uirements of
financing nee
The most com
ds. (pgs. 587–596)
mon techniqu
including both
e for
inco
presses expenses me statements and bala forecasting a firm’s pro form
nce sheets, is
, assets, and liabi
the percent-of-s a financial statements,
used to make
ales method,
the forecast can lities for a future period
which exas perc
computed over
come from the
several years,
most recent finan entages of sales. The perc
from the judg
methods.
entages
cial statemen
ment of the anal
yst, or from som ts, from an average
The primary obje
e combination
ctive of forecast
of these
financing that
ing a firm’s finan
the firm will
cing needs is
need to
mean those sour
to identify the
ces of financing seek from discretionary
amount of
sources. By disc
to use them. The
that require the
retionary sour new
se sources cont
firm’s managem
able), which
ces, we
rast with spon
arise naturally
taneous sources ent to make a conscious
in the course
decision
more products
of financing (suc
of doing busi
to
h as accounts
ness
firm in the form replenish its inventories,
the firm’s supp . For example, when the firm pay of accounts paya
liers automati
ble.
cally extend cred orders
KEY TERMS
it to the
Discretionary
financing need
page 590
s (DF
N),
The total amo
unt of financing
firm estimates
a
it will need for
a future perio
will not be fund
d that
ed by the reten
by increases in
tion of earnings
the firm’s acco
or
accrued expe
unts payable
nses.
and
Discretionary
sources of
financing, pag
590 Sources of
e
financing that
action by the
firm’s managem require explicit
ent. For exam
ple,
the decision to
borrow money
an example of
from a bank is
discretionary
financing, whe
the automatic
reas
finan
from an existing cing of inventory purchase
s
supplier that
increases the
accounts paya
firm’s
ble is not a disc
retionary sour
financing.
ce of
Percent-of-sal
financial forec es method, page 588
A
asting techniqu
e that uses the
portion of the
proitem being forec
ast (e.g., acco
unts
28/07/20 6:54 PM
Tools for Developing Study Skills
To be successful, finance students need hands-on opportunities to apply what they have learned in ways that go beyond
rote memorization of formulas. By focusing on basic principles of finance, students develop the skills needed to extend
their understanding of finance tools beyond formulas and canned answers. The authors’ objective is to equip students,
no matter what their major or business responsibility might be, to contribute to an analysis of the financial implications of
practical business decisions.
CHAPTER 11
Checkpoin
t 11.1
| Inve stm ent Dec isio
Calculatin
n Crit eria
Checkpoints provide a consistent problemsolving technique that walks through each problem
in five steps, including an analysis of the solution
reached. Each Checkpoint concludes with an
additional practice problem and its solution on the
same topic so students can test their mastery of
the problem-solving approach. Then students can
put their knowledge to the test by completing the
linked end-of-chapter Study Problem(s).
36 7
g the Net
Present
Project Long
requires an initia
Value fo
l investment
r Projec
$30,000 per
of $100,000
year in Years
t Long
and is expect
2 and 3, $25
ed to genera
The discount
,000 in Year
te cash flows
rate (k) approp
4, and $10,00
of $70,000 in
riate for calculat
ment opportu
0 in Year 5.
Year 1,
nity?
ing the NPV of
Project Long
is 17 percent.
Is Project Lon
STEP 1:
g a good inve
Picture the
stproblem
Project Long
requires an initia
l investment of
the next five
$100,000 and
years:
is expected to
produce the
following cas
h flows over
k = 17%
Time Period
Cash Flow
0
–$100,000
1
$70,000
2
$30,000
3
$30,000
4
5
$25,000
Years
$10,000
STEP 2:
Decide on
a solution
Our strategy
strategy
for analyzing
whether this is
of the cash inflo
a good investm
ws and then com
ent opportunity
paring them to
difference or
involves first calc
the NPV is pos
the amount of
ulating the pre
money invested
itive. The NPV
cash flows for
sent value
for Project Lon
, the initial cas
Years 1 through
g is equal to
h outflow, to see
5 minus the initia
lem. Thus, the
the present valu
if the
l cash outlay
first step in the
e of the project
(CF
solu
).
We can use Equ
’s expected
cash flows usin
tion is to calc
ulate the presen 0
ation (11–1) to
g k = 17%.
Then, from this
t value of the
solve this pro
We can calc
futu
bqua
re
ntity
cash flows by
ulate this pre
we subtract the
discounting the
sent value usin
or a spreadshe
initial cash out
g the mathema
lay of $100,0
et. We demons
00.
tics of discoun
trate all three
ted cash flow
methods her
STEP 3:
,
a financial calc
e.
Solve
ulator,
Using the
Mathema
tical Form
ulas. Using
Equ
ation (11–1),
NPV = -$100,
000 + $70,000
$30,000
$30,000
(1 + .17) 1 +
$25,000
Solving the equ
(1 + .17) 2 +
$10,000
(1 + .17) 3 +
ation, we get
(1 + .17) 4 +
(1 + .17) 5
NPV = –$1
00,000 + $59
,82
9
+
$21
= –$100,000
,915 + $18
,731 + $13,34
+ $118,378
1 + $4,561
= $18,378
Using a
Financia
l Calculat
by inputting CF;
or. Before
2nd; CE/C.
using the CF
button
Data and Key
Input
CF; −100,000;
ENTER
T ; 70,000; EN
TER
T ; 1; ENTER
T ; 30,000; EN
TER
T ; 2; ENTER
T ; 25,000; EN
TER
T ; 1; ENTER
T ; 10,000; EN
TER
T ; 1; ENTER
NPV; 17; EN
TER
T ; CPT
, make sure
Display
CF0 5 −100,0
00.00
C01 5 70,000
.00
F01 5 1.00
C02 5 30,000
.00
F02 5 2.00
C03 5 25,000
.00
F03 5 1.00
C04 5 10,000
.00
F04 5 1.00
I 5 17
NPV 5 18,378
you clear you
r calculator
518
PAR T 4 | Capit al Struc
Selected Firms (Yea
The debt ratio equals
r-End 2015)
the ratio of the firm’s
total liabilities to its total
including both intere
assets. Total liabilities
st-bearing debt and
equal the sum of curre
nonintere
st-bearing liabilities such
enterprise-value ratio
nt and long-term liabilit
equals the ratio of the
as accounts payable
ies,
firm’s short- and longand accrued expenses
its enterprise value.
term interest-bearing
. The debt-toThe times interest earne
debt
less excess cash and
d
ratio
equa
(EBIT) to its interest expe
ls the ratio of the firm’s
marketable securities
nse. The first two ratios
net operating incom
to
e or earnings before
measure the proportion
ratio measures the ability
interest and taxes
of the firm’s investmen
of the firm to make the
ts financed by borro
interest payments requi
wing, whereas the third
red to support its debt.
Debt Ratio
Total Liabilities
Total Assets
)
American Electric Powe
r (AEP)
Emerson Electric (EM
R)
Ford (F)
General Electric (GE)
Wal-Mart (WMT)
95.4%
71.8%
35.3%
87.9%
80.2%
60.0%
Average
67.1%
Maximum
Minimum
A01_TITM9824_14_GE_FM.indd 21
y
ital Structures for
American Airlines (AAL
“Tools of Financial Analysis” feature
boxes provide the students with a
quick reference source for the decision tools used in financial analysis.
This feature appears throughout the
book and names each calculation or
formula, displays it in equation form,
and summarizes what it tells you.
ture and Divid end Polic
Table 15.1 Financia
l and Cap
87.9%
35.3%
Debt-to-Enterprise-Value
Net Debt
Enterprise Value
28.2%
40.6%
11.6%
65.2%
19.1%
16.8%
30.7%
65.2%
11.6%
Ratio
Times Interest Earned
Net Operating Income
or EBIT
Interest Expense
4.79
3.65
19.26
4.32
2.82
11.03
8.21
19.26
2.82
For the set of firms in
Table 15.1, the average
ratio of operating inco
8.21, which indicates
me to interest expense
that the firms’ operating
is
earnings, on average,
pense by more than eigh
cover their interest ext times. This would surel
y make lenders feel more
be paid their interest
in a timely manner than
confident they will
if this ratio were close
We now have the follo
3
r
to
1 or less.
wing financial decision
tools to evaluate the firm’
Tools of Financial Analy
s capital structure.
sis—Capital Structure
Ratios
Name of Tool
Formula
Debt ratio
What It Tells You
Total Liabilities
• Measures the exten
Total Assets
t to whic
borrowed money to finan h the firm has used
ce its assets.
• A higher ratio indic
ates a greater reliance
on
non-owner financing
or financial leverage
Debt-to-enterpriseand
more financial risk taken
on by the firm.
BookValue of Interest@
value ratio
Excess
• A version of the debt
ratio that uses current
Bearing Debt
Cash
market values of equit
BookValue of Interest@
y as opposed to book
values.
Excess
a
Market Value of
Bearing Debt
b +
• The higher the debtCash
to-enterprise-value ratio
Equity
is,
the more financial risk
Net Debt
the firm is assuming.
=
Times interest
earned
Enterprise Value
Net Operating Incom
e or EBIT
Interest Expense
• Measures the firm’s
ability to pay its inter
est
expense from operating
income.
• A higher ratio indic
ates a greater capability
of
the firm to pay its inter
est expense in a timel
y
manner.
3
Some firms actually
have negative net debt.
That is, they have larger
than they have intere
excess cash and marke
st-bearing debt outsta
table securities balan
nding. This is fairly
maintain very large cash
ces
common for high-tech
balances as a reserve
firms like Apple (AAP
source of funding for
to finance in the public
L) that
investments in new techn
markets.
ologies that are difficu
lt
28/07/20 6:54 PM
Preface
The fourteenth Global Edition of Financial Management: Principles and Applications continues our pedagogical approach to make the material much engaging to all undergraduate
students, regardless of their major.
Our Approach to Financial Management
First-time students of finance will find that financial management builds on both economics and accounting. Economics provides much of the theory that underlies our
techniques, whereas accounting provides the input or data on which decision making is
based. Unfortunately, it is all too easy for students to lose sight of the logic that drives
finance and to focus instead on memorizing formulas and procedures. As a result, they
have a difficult time understanding how the various topics covered in an introductory
course tie together, and they do not appreciate how the financial insights may be useful
for them personally. More importantly, later in life when students encounter problems
that do not fit neatly into the textbook presentation, they may not be able to apply what
they have learned.
Our book is designed to overcome these problems. The opening chapter presents five
basic principles of finance that are woven throughout the book, creating a text tightly bound
around these guiding principles. In essence, students are presented with a cohesive, interrelated subject they can use when approaching future, as yet unknown, problems. We also recognize that most students taking introductory financial management are not finance majors,
and we include two features that help keep them engaged. At the beginning of each chapter,
we include a “Regardless of Your Major” feature box that explains why the issues raised in
the chapter are relevant to those students who are not finance majors. In addition, throughout
the book we have “Finance for Life” feature boxes that address issues like whether to buy or
lease a car and illustrate how students will be using the tools of financial analysis for personal
decisions throughout their lives.
Teaching an introductory finance class while faced with an ever-expanding discipline
puts additional pressures on the instructor. What to cover, what to omit, and how to make
these decisions while maintaining a cohesive presentation are inescapable questions. In dealing with these questions, we have attempted to present the chapters in a stand-alone fashion so
that they can easily be rearranged to fit almost any desired course structure and course length.
Because the principles are woven into every chapter, the presentation of the text remains
tight, regardless of whether or not the chapters are rearranged. Again, our goal is to provide
an enduring understanding of the basic tools and fundamental principles on which finance is
based. This foundation will give students beginning their studies in finance a strong base on
which to build future studies, and it will give students who take only one finance class a lasting understanding of the basics of finance.
Although historical developments, like the 2008 financial crisis, influence the topics that
are included in the introductory finance class, the underlying principles that guide f­ inancial
analysis remain the same. These principles are presented in an intuitively ­appealing manner
in Chapter 1 and thereafter are tied to all that follows. With a focus on these principles, we
provide an introduction to financial decision making rooted in financial ­theory. This focus
can be seen in a number of ways, perhaps the most obvious being the attention paid both to
valuation and to the capital markets as well as their influence on corporate financial decisions. What results is an introductory treatment of a discipline rather than the treatment of a
series of isolated finance problems. Our goal is to go beyond teaching the tools of financial
analysis and help students gain a complete understanding of the subject so they will be
able to apply what they have learned to new and unforeseen problems—in short, to educate
students in finance.
22
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PREFACE | 23
New to This Global Edition
The fourteenth Global Edition includes the following key updates:
• Updated “Finance for Life” feature boxes that analyze the text discussion of financial
management using real-world examples
• Updated end-of-chapter Study Problem sets
• Updated chapter-opening vignettes
• Updated Mini Cases
• Revised introductory chapters with new material and examples on business organization,
financial intermediation, and financial instruments around the world
A Total Learning Package
Financial Management is not simply another introductory finance text. It is a total learning
package that reflects the vitality of an ever-expanding discipline. Specifically, the fourteenth
Global Edition of Financial Management: Principles and Applications includes features with
benefits designed to address the seven key criteria outlined on the next page.
Learning Aids in the Text
The Five Principles of Finance Together, the five principles, Money Has a Time Value,
There Is a Risk-Return Tradeoff, Cash Flows Are the Source of Value, Market Prices Reflect
Information, and Individuals Respond to Incentives, represent the economic theory that makes
up the foundation of financial decision making and are woven throughout the chapters of the
book, providing the basis for focusing students on understanding the economic intuition rather
than just the mechanics of solving problems. They are integrated throughout the text in the
following ways:
• The five principles are introduced in Chapter 1 using examples that students can relate to
personally.
• They are revisited in the chapter openers with reference to their application to each chapter’s content.
• Specific reference is made throughout the text where the principles come to bear on the
discussion.
A Focus on Valuation Although many instructors make valuation the central theme of their
course, students often lose sight of this focus when reading their text. This text reinforces this
focus in some very concrete ways:
• First, as we mentioned earlier, we have built our discussion around five finance principles
that provide the foundation for the valuation of any investment.
• Second, we have introduced new topics in the context of “What is the value proposition?”
and “How is the value of the enterprise affected?”
Guided Solutions Videos These videos, which are available in MyLab Finance, have been
prepared for each of the Checkpoint examples in the text. They walk students through the solution to each example exercise and allow them to stop and rewatch as many times as needed
to grasp the problem solution.
“Finance for Life” A feature box that provides students with analysis parallel to the text
discussion of financial management but using examples they will likely experience in their
personal lives. Once again, this pedagogical tool is designed to make the study of finance
relevant to all students, regardless of their major.
Study Problem Sets Focusing on chapters with high problem usage, the end-of-chapter
Study Problem sets provide better problem choices for the instructor. As in the previous
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24
PREFACE |
Challenge
Solution
1. Finance books often show
the mechanics of finance but
do not present the intuition.
• The fourteenth Global Edition continues to utilize five key principles to help students understand financial management so that they can focus on the intuition behind the mechanics of
solving problems.
2. Students learn best when
they are actively engaged.
• A five-step problem-solving technique is used in fully worked-out examples called Checkpoints. These Checkpoints give students an opportunity to pause and test their comprehension
of the key quantitative concepts as they are presented. In the fifth step (“Check Yourself”),
students are given a practice problem similar to the preceding example to attempt on their
own. In addition, the “Check Yourself” steps are presented in Lecture Capture Videos that
are available on MyLab Finance. These videos walk students through each practice problem,
clearing up any questions they might have.
3. Student understanding and
motivation are improved
when concepts are applied to
topics that have relevance to
their lives.
• The feature box “Finance for Life” links important finance concepts to personal finance decisions that will be relevant throughout students’ lives.
• The feature box “Regardless of Your Major” illustrates that financial decision making often
requires a team that includes not only financial analysts but also engineers, operations people,
marketing people, and accountants. Just like finance majors need to know more than just
­finance, students pursuing these other majors need to know basic financial management to
serve effectively on these teams.
• The feature box “Finance in a Flat World” highlights international examples of financial
management concepts.
• End-of-chapter Study Questions are linked to these feature boxes to ensure that students have
the opportunity to actively engage with the ideas presented.
4. An undergraduate textbook
should provide meaningful
pedagogical aids to ensure
student comprehension and
retention.
• “Tools of Financial Analysis” feature boxes are provided throughout the text; they name the tool
being studied, provide its formula, and then explain what it tells students.
• Each pedagogical feature in the chapter has significance and relevance to the chapter topics,
and students are held accountable for the information therein.
• Designated end-of-chapter Study Questions key off the in-chapter feature boxes.
• The end-of-chapter Study Problems are labeled by major chapter section heads to guide students to the relevant chapter content.
5. Students often struggle with
the mathematical rigor of the
introductory finance course
and need an accessible
presentation of the mathematics.
• The “Tools of Financial Analysis” feature boxes provide students with clearly stated descriptions of what the essential equations or formulas tell them.
• We minimize the use of formulas when we can spell things out in plain English.
• We use a five-step procedure in our problem examples (called Checkpoints) that begins by
visualizing the problem graphically, describes a solution methodology, lays out all the necessary steps in the solution, and then interprets the solution by analyzing the underlying content
of the problem situation. In addition, the practice problems in the “Check Yourself” steps are
presented in Lecture Capture Videos that are available on MyLab Finance. These videos walk
students through each practice problem, clearing up any questions they might have.
• Financial management is a problem-solving course, so we provide lots of worked-out examples and have sorted the end-of-chapter materials by major chapter sections to guide students
to the relevant segment of the chapter.
• Figures are enhanced with notes and “talking boxes” that step students through the graphs and
highlight key points.
6. Instructors find assigning
and grading homework too
time-consuming.
• MyLab Finance allows instructors to create and assign tests, quizzes, or graded assignments
with ease.
• MyLab Finance handles the grading.
7. Students often miss the big
picture, viewing finance as
a presentation of several
loosely connected topics.
• The opening chapter presents five underlying principles of finance that serve as a springboard for
the chapters and topics that follow. In essence, students are presented with a cohesive, interrelated
perspective from which future problems can be approached.
• The core of finance involves trying to assess the valuation consequences of business decisions
in a wide variety of situations. Unfortunately, students often become so enmeshed in the details
of a business problem that they have difficulty identifying the valuation consequences of its
choices. To give students a context for their analysis, we use five guiding principles that underlie the valuation of any investment.
• With a focus on the big picture, we provide an introduction to financial decision making rooted
in current financial theory and in the current state of world economic conditions. What results
is an introductory treatment of a discipline rather than the treatment of a series of isolated
problems that face the financial manager. The goal of this text is not merely to teach the tools
of a discipline or trade but also to enable students to apply what is learned to new and as yet
unforeseen problems—in short, to educate students in finance.
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PREFACE | 25
edition, all Study Problem sets are organized by chapter section so that both instructors
and students can readily align text and problem materials. Where actual company examples are used, problems have been updated to reflect current conditions.
Real-World Examples To enhance the relevance of the topics discussed, we have made
extensive use of real-world examples. We provide ticker symbols in parentheses following
the names of real companies throughout the text. This makes it possible for students to easily
recognize examples that deal with actual companies.
A Multistep Approach to Problem Solving and Analysis As anyone who has taught
the core undergraduate finance course knows, students vary across a wide range in terms of
their math comprehension and skills. Students who do not have the math skills needed to
master the subject end up memorizing formulas rather than focusing on the analysis of business decisions using math as a tool. We address this problem in terms of both text content and
pedagogy.
• First, we present math only as a tool to help us analyze problems—and only when necessary. We do not present math for its own sake.
• Second, finance is an analytical subject and requires that students be able to solve problems. To help with this process, numbered chapter examples called Checkpoints appear
throughout the book. Each of these examples follows a very detailed, multistep approach
to problem solving that helps students develop their own problem-solving skills.
1. Step 1: Picture the problem. For example, if the problem involves a cash flow,
we will first sketch the timeline. This step also entails writing down everything we
know about the problem, which includes any relationships such as what fraction of
the cash flow is to be distributed to each of the parties involved and when it is to be
received or paid.
2. Step 2: Decide on a solution strategy. For example, what is the appropriate formula
to apply? How can a calculator or spreadsheet be used to “crunch the numbers”?
3. Step 3: Solve. Here we provide a completely worked-out, step-by-step solution. We
first present a description of the solution in prose and then provide a corresponding
mathematical implementation.
4. Step 4: Analyze. We end each solution with an analysis of what the solution means.
This emphasizes the point that problem solving is about analysis and decision making. Moreover, at this step we emphasize the fact that decisions are often based on
incomplete information, which requires the exercise of managerial judgment, a fact
of life that is often learned on the job.
5. Step 5: Check yourself. Immediately following the presentation of each new problem type, we include a practice problem that gives students the opportunity to practice the type of calculation used in the example. For students wanting more help,
the solutions to these “Check Yourself” problems are available as Lecture Capture
Videos in MyLab Finance.
Content-Enriched Tables and Figures Students today are visual learners. They are
used to scanning Internet sites to learn at a glance without the need to ferret out the meaning
of a printed page. Rather than seeing this as a negative, we think, instead, that students (and
we) are all the beneficiaries of a media revolution that allows us to learn quickly and easily
using graphic design and interactive software. Textbooks have been slow to respond to this
new way of absorbing information. In this text, the key elements of each chapter in the book
can quite literally be gleaned (reviewed) from the chapter tables, figures, and examples.
This means that all tables and figures are “content-enriched.” They are captioned, labeled
in detail, and carefully linked so as to make them useful as a stand-alone tool for reviewing
the chapter content.
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26
PREFACE |
“Finance for Life” These feature boxes apply the chapter concepts to personal financial
problems that students encounter in their daily lives.
“Finance in a Flat World” These feature boxes demonstrate how the chapter content
­applies to international business.
Figure Call-Outs Many figures include floating call-outs with descriptive annotations
­designed to highlight key points in the figures and facilitate student learning.
Figure and Table Captions Detailed captions describe the objective of each figure or table
and provide necessary background information so that its content can be easily understood.
This allows students to review the chapter content by scanning the figures and tables directly.
Equations Equations are written out in plain English with minimal use of acronyms and
abbreviations. In addition, “Tools of Financial Analysis” feature boxes are used throughout
the book to provide a quick review and reference guide for critical equations used to support
financial decision making.
Financial Spreadsheets and Calculators The use of financial spreadsheets and calculators has been integrated throughout the text. Thus, students have access to both methods of
problem solving. An appendix is provided that guides students through the use of both the HP
and the TI financial calculators. Excel files are available for worked-out examples and endof-chapter solutions.
Chapter Summaries The Chapter Summaries are organized around the chapter objectives.
Study Questions These end-of-chapter questions review the main concepts in the chapter
and are presented in the order in which these concepts were discussed in the chapter for easy
student reference.
Learning Aids Supplemental to the Text
Financial Management integrates the most advanced technology available to assist students
and instructors. Not only does this make Financial Management come alive with the most
current information, but also it fosters total understanding of all the tools and concepts necessary to master the course. Financial Management’s complete support package for students
and instructors includes these essentials.
MyLab Finance
This fully integrated online homework system gives students the hands-on practice and tutorial help they need to learn finance efficiently. Ample opportunities for online practice and
assessment in MyLab Finance are seamlessly integrated into each chapter.
• Auto-Graded Excel Projects Auto-graded Excel Projects allow instructors to seamlessly
integrate Excel content into their course without having to manually grade spreadsheets.
Students have the opportunity to practice important Finance skills in Microsoft Excel,
helping them to master key concepts and gain proficiency with Excel.
• Guided Solutions Videos These videos, which are available in MyLab Finance, have
been prepared for each of the Checkpoint examples in the text. They walk students
through the solution to each example exercise and allow them to stop and rewatch as
many times as needed to grasp the problem solution.
• Financial Calculator The Financial Calculator is available as a smartphone application,
as well as on a computer, and includes important functions such as cash flow, net present
value, and internal rate of return. Fifteen helpful tutorial videos show the many ways to
use the Financial Calculator in MyLab Finance.
• Interactive Figures Select in-text graphs and figures have been digitally enhanced to
allow students to interact with variables to affect outcomes and bring concepts to life.
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PREFACE | 27
• Pearson eText The Pearson eText keeps students engaged in learning on their own time,
while helping them achieve greater conceptual understanding of course material. The
worked examples, animations, and interactive tutorials bring learning to life, and algorithmic practice allows students to apply the very concepts they are reading about. Combining resources that illuminate content with accessible self-assessment, MyLab with
eText provides students with a complete digital learning experience—all in one place.
Instructor’s Manual with Solutions The complete text of the Solutions Manual is i­ ncluded
within the Instructor’s Manual for easy reference. The Instructor’s Manual was written by
Wendell Licon of Arizona State University and contains annotated chapter outlines, lecture
tips, and further questions for class discussion. The complete solutions to the chapter-ending
Study Questions, Study Problems, and Mini-Case problems are also included. The Instructor’s
Manual with Solutions is available for download as Microsoft Word and Adobe PDF files
from the Instructor Resource Center (accessible from http://www.pearsonglobaleditions.com).
Test Bank The Test Bank provides multiple-choice, true/false, and short-answer questions
with complete and detailed answers. As an additional resource, the Test Bank indicates questions that map to the standards set by the Association to Advance Collegiate Schools of Business so that instructors can track students’ mastery of these standards. Every question in the
Test Bank is also available in the TestGen software for both Windows and Macintosh computers. This easy-to-use testing software is a valuable test preparation tool that allows instructors
to view, edit, and add questions. The Test Bank is available for download from the Instructor
Resource Center accessible from http://www.pearsonglobaleditions.com, and all questions
can be assigned via MyLab Finance.
PowerPoint Presentation Lecture notes have been prepared by Philip Russel of Philadelphia University. These electronic slides include full-color presentations of chapter overviews
and examples coordinated with Financial Management, 14th Global Edition. The PowerPoint slides are available to download from the Instructor Resource Center, accessible from
http://www.pearsonglobaleditions.com.
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28
PREFACE |
Acknowledgments
We gratefully acknowledge the assistance, support, and encouragement of those individuals
who have contributed to Financial Management. Specifically, we wish to recognize the very
helpful insights provided by many of our colleagues. For their careful comments and helpful
reviews of this edition of the text, we are indebted to
Nazli Sila Alan, Fairfield University
Ross N. Dickens, University of Tennessee
at Martin
Caren Fullerton, Lubbock Christian University
Tuncer Gocmen, Shepherd University
Sonali Hazarika, Baruch College, City
University of New York
Jamie McCracken, Saint Mary-of-theWoods College
Keith Rhodd, SUNY Empire State
College—Metropolitan Center
Thomas Secrest, Coastal Carolina
University
We would also like to thank those who have provided helpful insights through their comments
on and reviews of past editions:
Kamal Abouzeid, V. T. Alaganan, Michael T. Alderson, Alexander Amati, Dwight C.
Anderson, Robert Antenucci, Nasser Arshadi, Curt Bacon, Nina Baranchuk, William Barbee,
Edward Baryla, Sung C. Bea, Laura Beal, Kenneth Beller, Gary Benesh, Laura Berk, Sam
G. Berry, Rafiqul Bhuyan, Randy Billingsley, Eric Blazer, Laurence E. Blouse, Russell P.
Boisjoly, Robert Boldin, Michael Bond, Richard Borghesi, Waldo L. Born, Virgil L. Brewer,
Jozelle Brister, Ted Bryley, Paul Burzik, John Byrd, Shelly Canterbury, Michael W. Carter,
Janice Caudill, Mary Chaffin, Don M. Chance, Perikolam Raman Chandy, Haiwei Chen, K.
C. Chen, Santosh Choudhury, Jeffrey S. Christensen, Ting-Heng Chu, M. C. Chung, Albert
H. Clark, Chris Clifford, David W. Cole, Roger Collier, Diane Coogan-Pushner, Douglas O.
Cook, Mariano Croce, Jay Dahya, Steven M. Dawson, Jared DeLisle, Yashwant S. Dhatt,
Prakash Dheeriya, Bernard C. Dill, Mark Dorfman, Robert Dubil, John W. Ellis, Suzanne Erickson, Jocelyn Evans, Marjorie Evert, Slim Feriani, Greg Filbeck, Sidney R. Finkel, Randy
Fisher, Fredrick G. Floss, Lyn Fraser, Mitchell Franklin, Eric Fricke, Lei Gao, Lucia Silva
Gao, John Gawryk, R. Philip Giles, John Glister, Devra Golbe, Ed Graham, Sharon S. Graham, Jack Griggs, Roxane M. Gunser, Nancy Lee Halford, Ken Halsey, Wendy D Habegger,
Mary Hartman, James D. Harris, William R. Henry, Richard Herron, Dr. Linda C. Hittle,
Stephen M. Horan, Keith Howe, Xiaoqing Hu, Charles R. Idol, Abu Jalal, Vahan Janjigian,
Timothy Jares, Nancy Jay, Jeff Jenkins, William Jens, Brad Johnson, Steve A. Johnson, Kyle
Jones, Kathleen Kahle, Ravi Kamath, Djavad Kashefinejad, Terry Keele, Jim Kehr, Eric Kelley, James D. Keys, Robert Kleiman, David R. Klock, Chet Lakhani, Reinhold P. Lamb, Larry
Lang, George B. F. Lanigan, Mark Laplante, William R. Lasher, Howard C. Launstein, Edward Lawrence, Rick LeCompte, Jeong Lee, Adam Lei, David E. Letourneau, Qian Li, Ralph
Lim, Yixin Liu, Lynda Livingston, Leonard T. Long, Yulong Ma, Richard MacMinn, Judy
E. Maese, William Mahnic, Abbas Mamoozadeh, Terry S. Maness, Balasundram Maniam,
Surendra K. Mansinghka, Leslie Mathis, Eric McLaughlin, James Milanese, James A. Miller,
Michael Milligan, Todd Mitton, Naval Modani, Eric J. Moon, Mark Moore, Scott Moore,
Anastasios Moysidis, M. P. Narayan, Willliam E. O’Connell, Jr., Kevin Okoeguale, Carrie
Pan, Donna Paul, Shalini Perumpral, Jeffrey H. Peterson, Mario Picconi, Ted R. Pilger, John
M. Pinkerton, Eric Powers, Mark Pyles, Mahmud Rahman, Arnold Redman, Eric Reiner,
Foster Roden, Stuart Rosenstein, Camelia Rotaru, Ivan C. Roten, Marjorie A. Rubash, Jack
H. Rubens, Todd Schank, Martina Schmidt, Oliver Schnusenberg, Tayyeb Shabbir, Peter A.
Sharp, Michael Sher, Jackie Shu, Michael Solt, Raymond F. Spudeck, Suresh Srivastava,
Joseph Stanford, John Stansfield, Edward Stendardi, Donald L. Stevens, Glenn L. Stevens,
Diane Suhler, David Suk, Elizabeth Sun, Janikan Supanvanij, L. E. Sweeney, Philip R. Swensen,
R. Bruce Swensen, Amir Tavakkol, Lee Tenpao, John G. Thatcher, Gary L. Trennepohl, Ronald Tsang, Paul A. Vanderheiden, K. G. Viswananthan, Gwendolyn Webb, Al Webster, Patricia Webster, Paul Weinstock, Herbert Weintraub, Kenneth L. Westby, Susan White, Matthew
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PREFACE | 29
Will, Sandra Williams, Herbert Witt, Alan Wolk, Lawrence C. Wolken, Annie Wong, Kevin
Woods, Steve B. Wyatt, Jasmine Yur-Austin, Kenneth Yung, Wold Zemedkun, Marc Zenner,
Zhong-guo Zhou, and Kermit C. Zieg, Jr.
As a final word, we express our sincere thanks to those who are using Financial
­Management: Principles and Applications in the classroom. We thank you for making us a
part of your teaching-learning team. Please feel free to contact any member of the author team
should you have questions or needs.
Acknowledgments for the Fourteenth
Global Edition
Pearson would like to thank Mohammad Rajjaque for his extensive work on this Global
­Edition. Mohammad worked in financial services dealing with micro finance and c­ ommodities
markets before starting a career in academics at the University of Sheffield, where he teaches
courses on financial management and is the Program Director for the undergraduate course. He
is a fellow of HEA, UK, and a Certified Business and Management Educator from C
­ hartered
Association of Business Schools, UK. His research interests are in socially ­responsible
­investment and risk management through the perspective of investment management.
Global Edition Reviewers
Davide Avino, Swansea University
Rezart Erindi, CFA
Catherine Lions, Umeå School of Business
Onur Tosun, University of Warwick
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Prepare, Apply, and Confirm
•
•
Auto-Graded Excel Projects—Using proven, field-tested technology,
MyLab Finance’s new auto-graded Excel Projects allow instructors to seamlessly
integrate Excel content into their course without having to manually grade
spreadsheets. Students have the opportunity to practice important Finance skills
in Microsoft Excel, helping them to master key concepts and gain proficiency with
Excel. Available with select titles.
Pearson eText—The Pearson eText gives students access to their textbook
anytime, anywhere. In addition to note-taking, highlighting, and bookmarking, the
and learn through author videos and more. Instructors can share comments or
highlights, and students can add their own, for a tight community of learners in
any class.
•
•
Dynamic Study Modules—With a focus on key topics, these modules work by
continuously assessing student performance and activity in real time and, using data and
analytics, provide personalized content to reinforce concepts that target each student’s
particular strengths and weakness.
Hallmark Features—Personalized Learning Aids, like Help Me Solve This, View an
Example, and instant feedback are available for further practice and mastery when
students need the help most!
•
•
Learning Catalytics—Generates classroom discussion, guides lecture,
and promotes peer-to-peer learning with real-time analytics. Now,
students can use any device to interact in the classroom.
Personalized Study Plan—Assists students in monitoring their own progress by
Includes regenerated exercises with unlimited practice, as well as the opportunity to
earn mastery points by completing quizzes on recommended learning objectives.
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with MyLab Finance
•
Worked Solutions—Provide step-by-step explanations on how to solve select
problems using the exact numbers and data that were presented in the problem.
Instructors will have access to the Worked Solutions in preview and review mode.
•
•
Financial Calculator—The Financial Calculator is available as a smartphone
application, as well as on a computer, and includes important functions such as cash
flow, net present value, and internal rate of return. Fifteen helpful tutorial videos show
the many ways to use the Financial Calculator in MyLab Finance.
•
•
Algorithmic Test Bank—Instructors have the ability to create
multiple versions of a test or extra practice for students. Available
with select titles.
123
Reporting Dashboard—View, analyze, and report learning outcomes clearly
and easily. Available via the Gradebook and fully mobile-ready, the Reporting
Dashboard presents student performance data at the class, section, and program
levels in an accessible, visual manner.
LMS Integration—Link from any LMS platform to access assignments, rosters, and
resources, and synchronize MyLab grades with your LMS gradebook. For students, new
direct, single sign-on provides access to all the personalized learning MyLab resources that
•
Mobile Ready—Students and instructors can access multimedia resources
and complete assessments right at their fingertips,
on any mobile device.
ALWAYS LEARNING
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CHAPTER # | Chapter Title 33
Financial Management
Principles and Applications­
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Introduction to Financial Management
(Chapters 1, 2, 3, 4)
Part 4
Capital Structure and Dividend Policy
(Chapters 15, 16)
Part 2
Valuation of Financial Assets
(Chapters 5, 6, 7, 8, 9, 10)
Part 5
Liquidity Management and Special Topics in Finance
(Chapters 17, 18, 19, 20)
Part 3
Capital Budgeting (Chapters 11, 12, 13, 14)
C H A P T E R
1
Part 1
Getting Started
Principles of Finance
Chapter Outline
1.1
Finance: An Overview
(pgs. 36–37)
1.2
Types of Business
Organizations (pgs. 37–41)
1.3
The Goal of the Financial
Manager (pgs. 41–43)
1.4
The Five Basic Principles of
Finance (pgs. 43–46)
Objective 1. Understand the importance of finance
in your personal and professional lives and identify
the three primary business decisions that financial
managers make.
Objective 2. Identify the key differences among the
three major legal forms of business.
Objective 3. Understand the role of the financial
manager within the firm and the goal for making
financial choices.
Objective 4. Explain the five principles of finance that
form the basis of financial management for both
businesses and individuals.
34
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Principles P 1, P 2, P 3, P 4, and P 5 Applied
This book examines a wide range of financial decisions that
people make in their business lives as well as in their personal
lives. In this chapter, we lay a foundation for the entire book by
describing the boundaries of the study of finance, the different
ways that businesses are organized, and the role that the financial manager plays within the firm. We also address some of
the ethical dilemmas that the financial manager must face daily.
Finally, we take an in-depth look at the five principles of finance
that underlie all financial decisions: P Principle 1: Money Has
a Time Value, P Principle 2: There Is a Risk-Return Tradeoff,
P Principle 3: Cash Flows Are the Source of Value, P Principle 4: Market Prices Reflect Information, and P Principle 5:
Individuals Respond to Incentives.
Every year the Volkswagen Group, based in Wolfsburg,
Germany, delivers over 10 million vehicles to its customers across the world. This group is the largest carmaker in Europe and owns 12 well-recognized brands,
­including Audi, SEAT, ŠKODA, Bentley, Bugatti, Lamborghini, Porsche, and Ducati. In order to run such a diverse portfolio of businesses, its management is
regularly faced with a number of significant decisions: it has to evaluate potential new products, invest in
R&D projects, scour new locations to set up production or R&D facilities, and so on. Each of these decisions will affect the future cost and revenue of the business, influencing the amount of cash it generates.
Therefore, we view these as financial decisions. Financial management is an integral part of any business
and impacts almost every other business function.
Like Volkswagen, you make financial decisions in your own life. Whether you’re evaluating the terms of
a banks loan for housing or deciding between a master’s degree right after graduation and working full time
for a year or two, you will find that these decisions use the same fundamental principles that guide business
decisions.
35
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Regardless of Your Major…
Welcome to the
World of Finance”
For the rest of your life, you will be both
working and living in a world where you will
be making choices that have financial consequences. Corporations make money by
introducing new products, opening new sales outlets, hiring the best people, and improving
productivity. All of these actions involve investing or spending money today with the hope of
generating more money in the future. Regardless of your major, after graduation you are likely
to be working for an organization where your choices have uncertain costs and benefits, both
now and in the future. This will be the case if you are working for a major corporation such as
General Electric (GE), starting your own firm, or working for a nonprofit organization such as St.
Jude Children’s Research Hospital. Moreover, you will be faced with a variety of personal
choices—whether you can afford a new car or a mortgage or how much to begin investing
in a retirement fund—that also require you to evaluate alternatives that involve uncertain
future payoffs. Regardless of your major, there is simply no getting around the fact that you will
be making financial choices throughout your life.
“
Your Turn: See Study Question 1–1.
1.1
Finance: An Overview
To begin our study of business finance, we present an overview of the field and define the
types of decisions addressed by the study of business finance. We also discuss the motivation
for studying finance and briefly introduce the five principles of finance.
What Is Finance?
Finance is the study of how people and businesses evaluate investments and raise capital to
fund them. Our interpretation of an investment is quite broad. In 2016, when Fitbit introduced
the Fitbit Blaze, an activity-focused smartwatch, it was clearly making a long-term investment.
The firm had to devote considerable expense to designing, producing, and marketing the smartwatch with the hope that it would eventually capture a sufficient amount of market share from
the Apple Watch and Android Wear smartwatch to make the investment worthwhile. But Fitbit
also makes an investment decision whenever it hires a fresh new graduate, knowing that it will
be paying a salary for at least six months before the employee will have much to contribute.
Thus, three basic questions are addressed by the study of finance:
1. What long-term investments should the firm undertake? This area of finance is generally
referred to as capital budgeting.
2. How should the firm raise money to fund these investments? The firm’s funding choices
are generally referred to as capital structure decisions.
3. How can the firm best manage its cash flows as they arise in its day-to-day operations?
This area of finance is generally referred to as working capital management.
We’ll be looking at each of these three areas of business finance—capital budgeting,
capital structure, and working capital management—in the chapters ahead.
Why Study Finance?
Even if you are not planning a career in finance, a working knowledge of finance will take you
far in both your personal and your professional lives.
Those interested in management will need to study topics such as strategic planning, personnel, organizational behavior, and human relations, all of which involve spending money
today in the hope of generating more money in the future. For example, in 2019 Paypal and
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other investors raised $110 million to invest in Tala1, a mobile money start-up, that makes
small loans—as little as $70 on average—to informal sector workers in developing countries
as they typically do not have access to mainstream financial services due to lack of credit history. This is a major strategic decision that will help Paypal penetrate previously unprofitable
market segments. Another example is that of Volkswagen, which in 2019 decided to invest
€33 billion2 over a course of four years to develop a range of electric vehicles. This is another
strategic decision, arising from a change in organizational goals due to the European Union’s
strict regulation to phase out internal combustion engines and anticipated competition. Similarly, marketing majors will need to understand how to price products, when to price them aggressively, and how much to spend on advertising them. Because aggressive marketing costs
money today but generates rewards in the future, it should be viewed as an investment that the
firm needs to finance. Production and operations management majors will need to understand
how best to manage a firm’s production and control its inventory and supply chain. All these
topics involve risky choices that relate to the management of money over time, which is the
central focus of finance.
Although finance is primarily about the management of money, a key component of
finance is the management and interpretation of information. Indeed, if you pursue a career in
management information systems or accounting, finance managers are likely to be your most
important clients.
For the student with entrepreneurial aspirations, an understanding of finance is essential—
after all, if you can’t manage your finances, you won’t be in business very long.
Finally, an understanding of finance is important to you as an individual. The fact that
you are reading this book indicates that you understand the importance of investing in yourself. By obtaining a college degree, you are clearly making sacrifices in the hope of making
yourself more employable and improving your chances of having a rewarding and challenging career. Some of you are relying on your own earnings and the earnings of your parents to
finance your education, whereas others are raising money or borrowing it from the financial
markets, institutions that facilitate financial transactions.
Financial decisions are everywhere, both in your personal life and in your career. Although
the primary focus of this book is on developing the corporate finance tools and techniques that are
used in the business world, you will find that much of the logic and many of the tools we develop
and explore along the way will also apply to decisions you will be making in your personal life. In
the future, both your business and your personal lives will be spent in the world of finance. Because
you’re going to be living in that world, it’s time to learn about its basic principles.
We will take an in-depth look at these principles at the end of this chapter. As you will
see, you do not need an extensive knowledge of finance to understand these principles, and,
once you know and understand them, they will help you understand the rest of the concepts
presented in this book. When you are looking at more complex financial concepts, think of
these principles as taking you back to the roots of finance.
Before you move on to 1.2
Concept Check | 1.1
1. What are the three basic types of issues that arise in business that are addressed by the study of business finance?
2. List three nonfinance careers to which the study of finance applies.
1.2
Types of Business Organizations
Although numerous and diverse, the legal forms of business organization around the world
have evolved around three structural themes: the sole proprietorship, the partnership, and the
­limited company. We will also discuss the charity and the cooperative in this section.
1
https://economictimes.indiatimes.com/industry/banking/finance/fintech-tala-raises-110m-in-series-d-funding-ledby-rps-ventures/articleshow/70780411.cms?from=mdr
2
https://www.ft.com/content/9c99411c-07ab-11ea-a984-fbbacad9e7dd
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Sole Proprietorship
The sole proprietorship is a business owned by a single individual who is entitled to all of
the firm’s profits and who is also responsible for all of the firm’s debt—that is, what the firm
owes. In effect, there is no separation between the business and the owner when it comes to
being liable for debts or being sued. If sole proprietors are sued, they can lose not only all they
invested in the proprietorship but also all their personal assets. A sole proprietorship is often
used in the initial stages of a firm’s life. This is in part because forming a sole proprietorship
is very easy; there are no forms to file and no partners to consult—the founder of the business is the sole owner. However, these organizations usually have limited access to outside
sources of financing. The owner of a sole proprietorship typically raises money by investing
his or her own funds and by borrowing from a bank. However, because there is no difference
between the sole proprietor and the business, there is no difference between personal borrowing and business borrowing. The owner of the business is personally liable for the debts of
that business while profits are taxed at the owner’s tax rate. In addition to bank loans, personal
loans from friends and family are important sources of financing for sole proprietorships. Sole
proprietorship is the most popular form of business organization around the world. In terms of
number of businesses, they account for 73 percent of the businesses in the United States3 and
59 percent of the businesses in the United Kingdom4. This number is estimated to be just over
50 percent5 for China and around 63 percent of businesses in India6. The actual figure is likely
to be higher because of a large number of unregistered micro businesses that do not appear in
the official data in developing countries.
Partnership
A general partnership is an association of two or more persons who come together as
­co-owners for the purpose of operating a business for profit. Just as with the sole proprietorship, there is no separation between the general partnership and its owners with respect to
being liable for debts or being sued. Its primary point of distinction from a sole proprietorship
is that the partnership has more than one owner. Just like with a “sole proprietorship,” the
profits of the partnership are taxed as personal income. An important advantage of the partnership is that it provides access to equity, or ownership, as well as financing from multiple owners
in return for partnership shares, or units of ownership.
In a limited partnership, there are two classes of partners: general and limited. The
general partner actually runs the business and faces unlimited liability for the firm’s debts,
whereas the limited partner is liable only up to the amount the limited partner invested. The
life of the partnership is tied to the life of the general partner, just as that of the sole proprietorship is tied to the life of the owner. In addition, it is difficult to transfer ownership of the
general partner’s interest in the business—this generally requires the formation of a new partnership. However, the limited partner’s shares can be transferred to another owner without the
need to dissolve the partnership, although finding a buyer may be difficult.
Corporation
If very large sums of money are needed to build a business, then the typical organizational form
chosen is the corporation. The major boost for this type of business organization was during
the early 1800s when steam engines made lucrative business options out of large railroads and
shipping companies. The corporation legally functions separately and apart from its owners (the
shareholders, also referred to as the stockholders). As such, the corporation can individually
sue and be sued and can purchase, sell, or own property, and its personnel are subject to criminal
punishment for crimes committed in the name of the corporation.
There are three primary advantages of this separate legal status. First, the owners’
­liability is confined to the amount of their investment in the company. In other words, if
3
https://bigideasforsmallbusiness.com/sole-proprietorships-continue-to-increase-in-numbers/
https://www.fsb.org.uk/uk-small-business-statistics.html
5
https://tradingeconomics.com/china/percent-of-firms-with-legal-status-of-sole-proprietorship-wb-data.html
6
https://tradingeconomics.com/india/percent-of-firms-with-legal-status-of-sole-proprietorship-wb-data.html
4
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the corporation goes under, the owners can lose only their investment. This is an extremely
important advantage of a corporation. After all, would you be willing to invest in an airline
company if you would be held personally liable if one of its planes crashed? The second
advantage of separate legal status for the corporation is that the life of the business is not
tied to the status of the investors. The death or withdrawal of an investor does not affect the
continuity of the corporation. The management continues to run the corporation when the
ownership shares are sold or passed on through inheritance. For example, some businesses
in Japan are claimed to have been operating under this structure since sixth century and are
over 1,500 years old. Finally, these two advantages result in a third advantage, the ease of
raising capital. It is much easier to convince investors to put their money in a corporation
when they know that the most they can lose is what they invest and that they can easily sell
their stock if they wish to do so.
The corporation is legally owned by its current set of stockholders, or owners, who elect a
board of directors. The directors then appoint managers who are responsible for determining the
firm’s direction and policies. Although even very small firms can be organized as corporations,
it is usually the larger firms that need to raise large sums of money for investment and expansion that use this organizational form. As such, this is the legal form of business that we will be
examining most frequently in this textbook.
One of the drawbacks of the corporate form is the double taxation of earnings that are paid
out in the form of dividends. When a corporation earns a profit, it pays taxes on that profit (the
first taxation of earnings) and pays some of that profit back to the shareholders in the form of
dividends. Then the shareholders pay personal income taxes on those dividends (the second
taxation of earnings). In contrast, the earnings of proprietorships and partnerships are not subject
to double taxation. Needless to say, this is a major disadvantage of corporations.
In the United States, an attractive alternative to the corporation for a small business is the
limited liability company (LLC), a cross between a partnership and a corporation. An LLC
combines the tax benefits of a partnership (no double taxation of earnings) with the limited
­liability benefit of a corporation (the owners’ liability is limited to what they invested). Because
LLCs operate under state laws, both the states and the Internal Revenue Service (IRS) have rules
for what qualifies as an LLC, and different states have different rules.
Further, there is a distinction between a private limited company and a public limited
company. A private limited company is not registered on any stock exchange and therefore
its shares are not publicly traded. They can only be traded under private arrangements with
mutual agreement. Family owned firms tend to be private limited companies. By contrast, a
public limited company is registered on a stock exchange and its shares can be bought and
sold by anyone. This results in regulation to protect shareholders’ interests, which adds to
cost. For example, a company listed on the main list of the London Stock Exchange can be
expected to spend at least an additional £1 million on accounting and disclosure related activities to meet these legal requirements.
The corporation is the most successful form of business organization across the world. It is
the business form that provides the easiest access to capital. As a result, it is the most common
choice for firms that are growing and need to raise money. For example, the market value of Microsoft in first quarter of 2020 was above $1.3 trillion. According to the World Bank’s estimate,
this is higher than the GDP of 170 countries in the world.
Not-for-Profit Organization
A not-for-profit organization (NPO) is created with specific objectives of promoting a s­ ocial
cause. NPOs come in all shapes and sizes: they can be global organizations like the United
Nations, Oxfam, and Missionaries of Charity and small organizations like a local football
club. NPOs are usually either exempted from taxes or pay lower taxes than corporations. They
may create surplus from their operations, but that is not their primary criterion. However, just
like commercial firms, it is important for an NPO to have sound financial management to
ensure that its operations are sustainable. While some of mainstream financial management
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principles that will be discussed in this book may not apply to an NPO, it would still need
to manage risk, e­ valuate projects, and prepare financial projections as these are some of the
primary functions of financial management in any organization.
Co-operative
A co-operative is owned and governed by its members, who also tend to be buyers of their
product or services. Co-operatives have been very successful in agricultural and housing loan
markets. Some. Countries like France, Germany, Switzerland, and India promote co-operatives
as a matter of policy and have very favorable regulations to promote them in various sectors.
Co-operatives cannot issue shares to external investors and require special financing methods to
raise capital for investing in their projects.
How Does Finance Fit into the Firm’s
Organizational Structure?
Finance is intimately woven into any aspect of the business that involves the payment
or receipt of money in the future. For this reason, it is important that everyone in a business
have a good working knowledge of the basic principles of finance. However, within a large
business organization, the responsibility for managing the firm’s financial affairs falls to the
firm’s chief financial officer (CFO).
Figure 1.1 shows how the finance function fits into a firm’s organizational chart. In the
typical large corporation, the CFO serves under the corporation’s chief executive officer
(CEO) and is responsible for overseeing the firm’s finance-related activities. Typically, both
Figure 1.1
How the Finance Area Fits into a Corporation
A firm’s vice president of finance is many times called its chief financial officer, or CFO. This person
oversees all of the firm’s financial activities through the offices of the firm’s treasurer and controller.
Board of Directors
Chief Executive Officer
(CEO)
Vice President—
Marketing
Vice President—Finance
or
Chief Financial Officer (CFO)
Duties:
Oversight of financial planning
Corporate strategic planning
Control of corporate cash flow
Treasurer
Duties:
Cash management
Credit management
Capital expenditures
Acquisition of capital
Financial planning
Management of foreign currencies
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Vice President—
Production and Operations
Controller
Duties:
Taxes
Financial statements
Cost accounting
Data processing
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a treasurer and a controller serve under the CFO, although in a small firm the same person may
fulfill both roles. The treasurer generally handles the firm’s financing activities. These include
managing the firm’s cash and credit, exercising control over its major spending decisions,
raising money, developing financial plans, and managing any foreign currency it receives.
The controller is responsible for managing the firm’s accounting duties. These include producing financial statements, paying taxes, and gathering and monitoring data that the firm’s
executives need to oversee its financial well-being.
Before you move on to 1.3
Concept Check | 1.2
1. What are the primary differences among a sole proprietorship, a partnership, and a corporation?
2. Explain why large and growing firms tend to choose the corporate form of organization.
3. What are the duties of a corporate treasurer?
4. What are the duties of a corporate controller?
1.3
The Goal of the Financial Manager
In 2001, Tony Fadell turned to Apple, Inc. (AAPL), to develop his idea for a new MP3 player.
Fadell’s idea had already been rejected by his previous employer and another company, but
the executives at Apple were enthusiastic about it. They hired Fadell, and the rest is history.
The successful sales of the new iPod MP3 player, coupled with efficient uses of financing and
day-to-day funding, raised the firm’s stock price. This exemplifies how a management team
appointed by a corporate board made an important investment decision that had a very positive effect on the firm’s total value.
As previously mentioned, we can characterize the financial activities of a firm’s management in terms of three important functions within a firm. These are illustrated here using
Apple’s iPod example:
• Making investment decisions (capital budgeting decisions): Apple’s decision to introduce the iPod, which later led to the iPhone.
• Making decisions on how to finance these investments (capital structure decisions): Apple’s decision on how to finance the development and production of the iPod and eventually the iPhone.
• Making decisions on how best to manage the company’s day-to-day operations (working
capital management): Apple’s decision regarding how much inventory to hold.
In carrying out these tasks, financial managers must be aware that they are ultimately
working for the firm’s shareholders, who are the owners of the firm, and that the choices
they make as financial managers will generally have a direct impact on their shareholders’ wealth.
Maximizing Shareholder Wealth
With a publicly owned corporation such as Coca-Cola (KO), the shareholders who purchase stock in the company elect a board of directors that, among other duties, selects
the company’s CEO. These shareholders, ranging from individuals who purchase stock
for a retirement fund to large financial institutions, have a vested interest in the company. Because they are the company’s true owners, that company will commonly have
a principal goal described as maximizing shareholder wealth, which is achieved by
maximizing the stock price.
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With all this in mind, let’s take a look at Coca-Cola’s “vision” statement. While maximization of shareholder wealth is included, it is surrounded by other goals that range from
sustainable growth to being responsible. It also aims Coca-Cola’s efforts toward creating a
caring workplace and taking care of its customers. Clearly, Coca-Cola goes well beyond the
traditional goal of maximization of shareholder wealth, but each of these goals plays a part
in creating a successful business, which in turn should be beneficial to the shareholder in the
long run.
Now let’s examine Google, Inc. (GOOG). For years, Google stated on the corporate
portion of its website that its goal was “to develop services that significantly improve the
lives of as many people as possible,” and its first motto was simply “Don’t be evil.” When
Google restructured under the conglomerate Alphabet, Inc., its motto became “Do the right
thing.” Does this mean that Google—or Alphabet, as it is now called—doesn’t care about
money or the firm’s owners (stockholders)? For the sake of all Alphabet stockholders, we
certainly hope not. After all, why do you buy stock in a company in the first place? You do
it in the hope of making money, right? It’s nice to be altruistic and make the world a better
place, but in reality, companies had better earn money if they expect banks to continue to
loan them money and stockholders to continue to buy their shares. Alphabet apparently
believes both goals are possible: The company says that in addition to making the world a
better place, it “will optimize for the long-term rather than trying to produce smooth earnings for each quarter.”
We believe, as Alphabet does, that maximizing the wealth of your shareholders and
doing the right thing can go hand in hand. Think of this goal not as moving away from
creating wealth for shareholders but as moving toward what will truly increase the value
of their shares in the long term. As we explain the concepts in this book, we will assume
that businesses don’t act out of greed to “get rich quick” and that they try to maximize
the wealth of their shareholders by making decisions that have long-term positive effects.
Very simply, managers can’t afford to ignore the fact that shareholders want to see the
value of their investments rise—they will sell their shares if it doesn’t. This, in turn, will
cause the company’s share price to fall, jeopardizing the managers’ jobs if they are seen
to have an excessively short-term focus.
Ethical Considerations in Corporate Finance
Although ethics is not one of the five principles of finance, it is fundamental to the notion
of trust and is therefore essential to doing business. The problem is that in order to cooperate, business participants have to rely on one another’s willingness to act fairly. Although
businesses frequently try to describe the rights and obligations of their dealings with others
using contracts, it is impossible to write a perfect contract. Consequently, business dealings between people and firms ultimately depend on the willingness of the parties to trust
one another.
Ethics, or a lack thereof, is a recurring theme in the news. Recently, finance has been
home to an almost continuous series of ethical lapses. Financial scandals at companies such
as Enron and WorldCom, Bernie Madoff’s Ponzi scheme, Satyam Computer Services in India
and, more recently, the Patisserie Valerie in the United Kingdom and Kangmei Pharmaceutical in China show that the business world does not forgive ethical lapses. Not only is acting in
an ethical manner morally correct, but also it is a necessary ingredient of long-term business
and personal success.
You might ask yourself, “As long as I’m not breaking society’s laws, why should I
care about ethics?” The answer to this question lies in consequences. Everyone makes
errors of judgment in business, which is to be expected in an uncertain world. But ethical errors are different. Even if they don’t result in anyone going to jail, they tend to
end careers and thereby terminate future opportunities. Why? Because unethical behavior destroys trust, and businesses cannot function without a certain degree of trust.
Throughout this book, we will point out some of the ethical pitfalls that have tripped
up managers.
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Regulation Aimed at Making the Goal of the Firm Work:
The Sarbanes–Oxley Act
Because of growing concerns about both agency and ethical issues, in 2002 Congress passed
the Sarbanes–Oxley Act—or SOX, as it is commonly called. One of the primary inspirations
for this new law was Enron, which failed financially in December 2001. Prior to bankruptcy,
Enron’s board of directors actually voted on two occasions to temporarily suspend its own
“code of ethics” to permit its CFO to engage in risky financial ventures that benefited the CFO
personally while exposing the corporation to substantial risk.
SOX holds corporate advisors who have access to or influence on company decisions
(such as a firm’s accountants, lawyers, company officers, and board of directors) legally
accountable for any instances of misconduct. The act very simply and directly identifies its
purpose as being “to protect investors by improving the accuracy and reliability of corporate
disclosures made pursuant to the securities laws, and for other purposes,” and it mandates
that senior executives take individual responsibility for the accuracy and completeness of the
firm’s financial reports.
SOX safeguards the interests of the shareholders by providing greater protection against
accounting fraud and financial misconduct. Unfortunately, all of this has come with a price.
Although SOX has received praise from the likes of former Federal Reserve Chairman Alan
Greenspan and has increased investor confidence in financial reporting, it has also been criticized. The demanding reporting requirements are quite costly and, as a result, may inhibit
firms from listing on U.S. stock markets.
Before you move on to 1.4
Concept Check | 1.3
1. What is the goal of a firm?
2. Why is ethics relevant to the financial management of a firm?
3. What is the Sarbanes–Oxley Act of 2002? What has it accomplished?
1.4
The Five Basic Principles of Finance
At first glance, finance can seem like a collection of unrelated decision rules. Nothing could
be further from the truth. The logic behind the financial concepts covered in this textbook
arises from five simple financial principles, each of which is described next.
Principle 1: Money Has a Time Value
A dollar received today is worth more than a dollar received in the future. Conversely, a dollar
received in the future is worth less than a dollar received today.
Perhaps the most fundamental principle of finance is that money has a time value. A
dollar received today is more valuable than a dollar received one year from now. That is, we
can invest the dollar we have today to earn interest so that at the end of one year we will have
more than one dollar.
Because we can earn interest on money received today, it is better to receive money
sooner rather than later. For example, suppose you have a choice of receiving $1,000 either
today or a year from now. If you decide to receive it a year from now, you will have passed up
the opportunity to earn a year’s interest on the money. Economists would say you suffered an
“opportunity loss” or an opportunity cost.
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P ART 1 | Introduction to Financial Management
Principle 2: There Is a Risk-Return Tradeoff
We won’t take on additional risk unless we expect to be compensated with additional return.
Principle 2 is based on the idea that individuals are risk-averse, which means that they
prefer to get a certain return on their investment rather than an uncertain return. However, the
world is an inherently risky place, so at least some individuals will have to make investments
that are risky. How are investors induced to hold these risky investments when there are safer
alternative investments? By offering investors a higher expected rate of return on the riskier
investments.
Notice that we refer to expected return rather than actual return. As investors, we have
expectations about what returns our investments will earn; however, a higher expected rate
of r­eturn is not always a higher realized rate of return. For example, you may have thought
­Netflix (NFLX) would do well in 2015, but did you really expect it would return 139.2
­percent? On the other hand, in July 2018, you may have invested in Fever-Tree, a UK-based
drinks company, as its share price had increased by almost 70 percent in one year following
good returns over the last three years. However, in the next two years, Fever-Tree’s actual
returns were –34 percent and –25 percent.
The risk-return relationship will be a key concept as we value assets and propose new
investment projects throughout this text. We will also describe how investors measure risk.
Interestingly, much of the work for which the 1990 Nobel Prize in Economics was awarded
centered on the graph shown in Figure 1.2 and how to measure risk. Both the graph and the
risk-return relationship it depicts will reappear often in this text.
Principle 3: Cash Flows Are the Source of Value
Profit is an accounting concept designed to measure a business’s performance over an interval
of time. Cash flow is the amount of cash that can actually be taken out of the business over
this same interval.
You may recall from your accounting classes that a company’s profits can differ dramatically from its cash flows. Cash flows represent actual money that can be spent, and, as we will
later discuss, they are what determines an investment’s value.
Profits are different. To determine a company’s accounting profit, its accountants have
to make a judgment about how the business’s costs and revenues are allocated to each time
period. Consequently, different judgments result in different profit measurements. In fact, a
firm can show a profit on paper even when it is generating no cash at all. This isn’t to say
that accounting profits are unimportant to investors. Investors see accounting profits as an
Figure 1.2
Expected return
There Is a Risk-Return Tradeoff
Investors demand a return for delaying their consumption. To convince them to take on added risk,
they demand a higher expected return.
Expected return
for taking on
added risk
Expected return
for delaying
consumption
Risk
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important indicator of a firm’s ability in the past—and perhaps in the future—to produce cash
flows for its investors. Therefore, to the extent that profits affect investors’ expectations, they
are an important source of information.
There is another important point we need to make about cash flows. Recall from your
economics classes that people make the best choices when they look at marginal, or incremental, cash flows. That’s why in this book we focus on the incremental cash flow to the company
as a whole that is produced as a consequence of a decision. The incremental cash flow to the
company as a whole is the difference between the cash flow to the company that would be
produced with the potential new investment and the cash flow that would be produced without that investment. To understand this concept, let’s think about the incremental cash flow
produced by Star Wars: The Force Awakens. Not only did Disney make a lot of money on this
movie, but also, once Disney finishes Star Wars Land, this movie will increase the number of
people attracted to Disney theme parks, along with resulting in sales of all kinds of Star Wars
items. Thus, if you were to evaluate Star Wars: The Force Awakens, you’d want to include
its impact on sales of Star Wars T-shirts, lightsabers, action figures, and all Star Wars related
items throughout the entire company.
Principle 4: Market Prices Reflect Information
Investors respond to new information by buying and selling their investments. The speed
with which investors act and the way that prices respond to the information determine the
efficiency of the market.
The prices of financial claims traded in the public financial markets respond rapidly to the
release of new information. Thus, when earnings reports come out, prices adjust immediately
to the new information, moving upward if the information is better than expected and downward if it is worse than expected. In efficient markets, such as those that exist in the United
States and other developed countries, this process takes place very quickly. As a result, it’s
hard to profit from trading on publicly released information.
To illustrate how quickly stock prices can react to information, consider the following
set of events: While Nike (NKE) CEO William Perez flew aboard the company’s Gulfstream
jet one day in November 2005, traders on the ground sold off a significant amount of Nike’s
stock. Why? Because the plane’s landing gear was malfunctioning, and they were watching
TV coverage of the event! While Perez was still in the air, Nike’s stock dropped 1.4 percent. Once Perez’s plane landed safely, Nike’s stock price immediately bounced back. This
example illustrates that in the financial markets there are ever-vigilant investors who are looking to act even in anticipation of the release of new information.
Consequently, managers can expect their company’s share prices to respond quickly to
the decisions they make. Good decisions will result in higher stock prices. Bad decisions will
result in lower stock prices.
Principle 5: Individuals Respond to Incentives
Incentives motivate, and the actions of managers are often motivated by self-interest, which
may result in managers not acting in the best interests of the firm’s owners. When this happens
the firm’s owners will lose value.
Managers respond to the incentives they are given in the workplace, and, when their
incentives are not properly aligned with those of the firm’s stockholders, they may not make
decisions that are consistent with increasing shareholder value. For example, a manager
may be in a position to evaluate an acquisition that happens to be owned by his brother-inlaw. Other situations are much less straightforward. For example, a financial manager may
be asked to decide whether or not to close a money-losing plant, a decision that, although
saving money for the firm, will involve the personally painful act of firing the employees
at the plant.
The conflict of interest between the firm’s managers and its stockholders is called a
principal-agent problem, or agency problem, in which the firm’s common stockholders, the
owners of the firm, are the principals in the relationship and the managers act as agents of
these owners. If the managers have little or no ownership in the firm, they have less incentive to work energetically for the company’s shareholders and may instead choose to enrich
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themselves with perks and other financial benefits—say, luxury corporate jets, expensive
corporate apartments, or resort vacations. They also have an incentive to turn down risky
investments that may jeopardize their jobs—even though their shareholders would like the company to pursue these projects. The lost shareholder value that results from managerial actions
that are inconsistent with the goal of maximizing shareholder value is called an agency cost.
Agency problems also arise when the firm’s executives are considering how to raise
money to finance the firm’s investments. In some situations, debt may be the cheapest source
of financing, but managers may avoid debt financing because they fear the loss of their jobs if
the firm is unable to pay its bills. Stockholders, on the other hand, might prefer that the firm
use more debt financing because it puts pressure on management to perform at a high level.
Agency costs are typically difficult to measure, but occasionally their effect on the firm’s
stock price can be seen. Agency costs are typically difficult to measure, but occasionally their
effect on the firm’s stock price can be seen. For example is China-based Luckin Coffee, a
chain of coffee shops across South-East Asia. It was one of the few Chinese companies with
a successful listing on NASDAQ in May 2019. In April 2020, it was revealed that sales of
approximately $310 million, almost 40 percent of their turnover, were recorded in fake transactions. Their share price dropped by almost 80 percent overnight.
Fortunately, there are several measures that can be taken to help mitigate the agency
problem:
• Compensation plans can be put in place that reward managers when they act to maximize
shareholder wealth.
• The board of directors can actively monitor the actions of managers and keep pressure on
them to act in the best interests of shareholders.
• The financial markets can (and do) play a role in monitoring management by having auditors, bankers, and credit agencies monitor the firm’s performance, while security analysts provide and disseminate information on how well the firm is doing, thereby helping
shareholders monitor the firm.
• Firms that underperform will see their stock prices fall and may be taken over and have
their management teams replaced.
To see the power of incentives, consider the case of the Italian unit of British Telecom
(BT), which reported inflated figures for earnings to the tune of £530 million in 2019. The
primary reason behind this was the tough targets set by BT’s top management in the United
Kingdom and the relentless pressure that the Italian unit was subsequently subjected to to
achieve these targets7. Sometimes the design of an incentive or bonus system may stimulate
managerial decision making in a way that goes against the interest of shareholders and even
other stakeholders.
Before you begin end-of-chapter material
Concept Check | 1.4
1. What are the five principles of finance?
2. A fundamental guiding principle of investing is that higher risks require higher rewards or returns. Give two examples of
the risk-return relationship.
3. What do we mean when we say that market prices reflect information?
7
https://www.thisismoney.co.uk/money/news/article-7353931/BT-faces-court-530m-Italian-fraud-law-firm-Enronvictory-targets-telecoms-giant.html
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47
Applying the Principles of Finance to Chapter 1
P Principle 2: There Is a Risk-Return Tradeoff We won’t take
on additional risk unless we expect to be compensated with additional return.
P Principle 3: Cash Flows Are the Source of Value Cash flow
measures the amount of cash that can actually be taken out of the business
over an interval of time. As a result, it is the source of value.
P Principle 4: Market Prices Reflect Information Investors respond to new information by buying and selling. As a result, prices reflect what
is known. The speed with which investors act and prices respond reflects the
efficiency of the market.
P Principle 5: Individuals Respond to Incentives Large firms
are often run by professional managers who own a small fraction of the firm’s
equity. The individual actions of these managers are often motivated by selfinterest, which may result in managers not acting in the best interest of the
firm’s owners. When this happens, the firm’s owners will lose value.
1.1
1
Chapter Summaries
C H A P T E R
P Principle 1: Money Has a Time Value A dollar received today is
worth more than a dollar received in the future. Conversely, a dollar received in
the future is worth less than a dollar received today.
Understand the importance of finance in your personal and professional
lives and identify the three primary business decisions that financial
managers make. (pgs. 36–37)
SUMMARY: Finance is the study of how individuals and businesses allocate money over time.
We all face choices that involve spending or receiving money now versus sometime in the future.
What you will learn in this book will help you to better understand how to make those choices, both
in your personal life and as a financial manager.
The decision-making process of planning and managing a firm’s long-term investments is
called capital budgeting. The mix of long-term sources of funds used by a firm to finance its operations is called its capital structure. Working capital management involves managing the firm’s
short-term investment in assets and liabilities and ensuring that the firm has sufficient resources to
maintain its day-to-day business operations.
Concept Check | 1.1
KEY TERMS
1. What are the three basic types
of issues that arise in business
that are addressed by the study
of business finance?
Capital budgeting, page 36 The decision-
2. List three nonfinance careers
to which the study of finance
applies.
term sources of funds used by the firm.
making process used to analyze potential investments in fixed assets.
Capital structure, page 36 The mix of long-
Working capital management, page
36 Management of day-to-day operations and
decisions related to working capital and shortterm financing.
Financial markets, page 37 Mechanisms
that allow people to easily buy and sell financial
claims.
1.2
Identify the key differences among the three major legal forms
of business. (pgs. 38–41)
SUMMARY: The sole proprietorship is a business operation owned and managed by a single
individual. Initiating this form of business is simple and generally does not involve any substantial
organizational costs. The proprietor has complete control of the firm but must be willing to assume
full responsibility for its outcomes.
Similar to the sole proprietorship, a general partnership is simply a coming together of two or
more individuals who face unlimited liability for their involvement in the partnership. The limited
partnership is another form of partnership sanctioned by states to permit all but one of the partners
to have limited liability if this is agreeable to all partners. The one partner with unlimited liability
is the general partner.
A business takes the form of a corporation when it has an increased need to raise capital from
public investors. Although greater organizational costs and regulations are imposed on this legal
entity, the corporation is more conducive to raising large amounts of capital. Limited liability,
continuity of life, and ease of transfer in ownership, all of which increase the marketability of
the investment, have greatly contributed to attracting large numbers of investors to the corporate
environment. The formal control of the corporation is vested in the parties who own the greatest
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P ART 1 | Introduction to Financial Management
number of shares. However, day-to-day operations are managed by the corporate officers, who
theoretically act on behalf of the stockholders. An attractive alternative to the corporation for a
small business is the limited liability company (LLC), a cross between a partnership and a corporation. An LLC combines the tax benefits of a partnership (no double taxation of earnings) and the
limited liability benefit of a corporation (the owners’ liability is limited to what they invest).
KEY TERMS
Corporation, page 38 A business entity that
legally functions separate and apart from its owners.
Debt, page 37 Money that has been borrowed
and must be repaid. This includes such things as
bank loans and bonds.
Dividends, page 39 The portion of a corporation’s earnings that is distributed to its
shareholders.
Equity, page 38 The ownership interest in a
corporation. It is the stockholders’ investment in
the firm and the cumulative profits retained in the
business up to the date of the balance sheet.
Concept Check | 1.2
1. What are the primary
differences among a sole
proprietorship, a partnership,
and a corporation?
2. Explain why large and growing
firms tend to choose the
corporate form of organization.
3. What are the duties of a
corporate treasurer?
in which all of the partners are fully liable for the
indebtedness incurred by the partnership.
Limited partnership, page 38 A partnership
in which one or more of the partners have limited
liability that is restricted to the amount of capital
they invest in the partnership.
Partnership, page 38 The joining together of
two or more individuals as co-owners to operate a
business for profit.
Shareholders, page 39 The owners of
the firm; those who own shares of stock in a
corporation.
Shares, page 38 Units of ownership.
Sole proprietorship, page 38 A business
owned by a single individual.
Stockholders, page 39 The owners of the
corporation’s stock. The corporation is legally
owned by its current set of stockholders, or
owners, who elect a board of directors.
elements of the partnership and corporate forms.
1.3
Concept Check | 1.3
1. What is the goal of a firm?
2. Why is ethics relevant to the
financial management of a firm?
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General partnership, page 38 A partnership
Limited liability company (LLC), page
39 A business organizational form that blends
4. What are the duties of a
corporate controller?
3. What is the Sarbanes–Oxley
Act of 2002? What has it
accomplished?
General partner, page 38 A member of a
general partnership or a member of a limited partnership who actually runs the business and faces
unlimited liability for the firm’s debts.
Limited partner, page 38 A member of a
limited partnership who is liable only up to the
amount invested by that member.
Understand the role of the financial manager within the firm
and the goal for making financial choices. (pgs. 41–43)
SUMMARY: The finance function in most large firms is headed by a vice president of finance
or chief financial officer (CFO). The CFO typically reports directly to the firm’s chief executive
officer (CEO). The CFO oversees the firm’s financing decisions, including the management of the
firm’s cash position (in larger firms, this responsibility is delegated to the company treasurer, who
reports to the CFO) as well as corporate reporting and general accounting (once again, in large
firms this task is delegated to the company controller, who also reports to the CFO).
A critically important goal of finance is to design incentive compensation plans that better
align the interests of managers with those of the firm’s owners (stockholders).
Firms are in business to make their owners, or shareholders, wealthier. With this goal in
mind, financial managers must make financial decisions regarding long-term investments, financing, and the management of short-term cash needs. For very large firms whose shares of
stock are publicly traded, this goal is commonly described as maximizing the wealth of shareholders (the business’s owners).
In finance, ethics—or a lack thereof—is a recurring theme in the news. Ethics is fundamental
to the notion of trust and is therefore essential to doing business. In order to cooperate, business
participants have to rely on one another’s willingness to act fairly.
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CHAPTER 1 | Getting Started
1.4
49
Explain the five principles of finance that form the basis of financial
management for both businesses and individuals. (pgs. 43–46)
SUMMARY:
P Principle 1: Money Has a Time Value
A dollar received today is worth more than a dollar received in the future. Conversely, a dollar
received in the future is worth less than a dollar received today.
P Principle 2: There Is a Risk-Return Tradeoff
We won’t take on additional risk unless we expect to be compensated with additional return.
Concept Check | 1.4
1. What are the five principles of
finance?
2. A fundamental guiding principle
of investing is that higher risks
require higher rewards or
returns. Give two examples of
the risk-return relationship.
3. What do we mean when we
say that market prices reflect
information?
P Principle 3: Cash Flows Are the Source of Value
Profit is an accounting concept designed to measure a business’s performance over an interval of
time. Cash flow is the amount of cash that can actually be taken out of the business over this same
interval.
P Principle 4: Market Prices Reflect Information
Investors respond to new information by buying and selling their investments. The speed with
which investors act and the way that prices respond to this information determine the efficiency
of the market.
P Principle 5: Individuals Respond to Incentives
Incentives motivate, and the actions of managers are often motivated by self-interest, which may
result in managers not acting in the best interests of the firm’s owners. When this happens, the
firm’s owners will lose value.
KEY TERMS
Agency problem, page 46 Conflicts that
arise out of the separation of management and
ownership of the firm.
Opportunity cost, page 44 The value of the
next best alternative that is foregone as a result of
making a decision.
Study Questions
1–1. In Regardless of Your Major: Welcome to the World of Finance on page 36, we discussed how the topic of Principle 1, the time value of money, is relevant to both your
personal and your professional lives. Describe a decision you might face in the future
that will require you to consider the future value of money received (or invested). For
example, how might the time value of money enter into a decision to push back your
graduation date by one year?
1–2. Explain the three types of business decisions that a financial manager faces.
1–3. According to Principle 2, how should investors decide where to invest their money?
1–4. Briefly discuss why the people who make financial decisions must focus on incremental cash flows when evaluating new projects.
1–5. List the three main forms of business organization, and describe their advantages and
disadvantages. If you were to consider starting up a lawn-care business for the summer, what type of business organization might you use?
1–6. Who really owns a corporation, and how does that impact the goal of the firm?
1–7. What goal do the owners of a for-profit business generally strive for?
1–8. Briefly discuss the incentives for financial managers to conduct their business in an
ethical manner.
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Part 1
Introduction to Financial Management
(Chapters 1, 2, 3, 4)
Part 2Valuation of Financial Assets
(Chapters 5, 6, 7, 8, 9, 10)
Capital Structure and Dividend Policy
(Chapters 15, 16)
Part 5
Liquidity Management and Special Topics in Finance
(Chapters 17, 18, 19, 20)
Capital Budgeting (Chapters 11, 12, 13, 14)
C H A P T E R
2
Part 3
Part 4
Firms and the Financial
Markets
Chapter Outline
2.1
The Basic Structure of
Financial Markets (pg. 52)
2.2
The Financial Marketplace:
Financial Institutions (pgs. 52–57)
2.3
The Financial Marketplace:
Securities Markets (pgs. 57–65)
Objective 1. Describe the structure and functions of
financial markets.
Objective 2. Distinguish between commercial banks
and other financial institutions in the financial
marketplace.
Objective 3. Describe the different securities markets
for bonds and stocks.
50
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Principles P 2, P 4, and P 5 Applied
When reading this chapter, you should keep in mind three of the
basic principles of finance introduced in Chapter 1: P Principle 2:
There Is a Risk-Return Tradeoff, P Principle 4: Market Prices
Reflect Information, and P Principle 5: Individuals Respond to
Incentives. Financial markets are organized to offer investors a
wide range of investment opportunities that have different risks
and different expected rates of return that reflect those risks. The
goal of these markets is to provide investors with opportunities
that best fit their risk and return objectives while at the same time
providing businesses with opportunities to raise funds—to train
employees, do research, and build new plants—at prices that appropriately reflect the prospects of these businesses.
If you wonder who the participants in financial markets are, the answer is surprisingly easy: it’s everyone. Anyone
who has a bank account, insurance, or a loan is participating in financial markets. As a student, you may have an
education loan. This implies you are spending more than you currently earn and have borrowed money through
the financial markets to finance your degree. When we need more money than we have, we borrow from the
financial markets in the form of a loan or a lease agreement. But once you graduate and enter the workforce, you
may earn more than you spend and, therefore, be able to save. When we have surplus money—more than we
need immediately—we hand it over to financial markets in the form of deposits in savings accounts; purchases
of shares, bonds, or mutual funds; or loans through a p2p channel.
In this chapter, we provide a preliminary overview of financial markets. We first review some of the primary
institutions that facilitate the transfer of money from investors to companies and individuals. Next, we discuss the
securities markets, in which different securities issued by businesses are bought and sold. The primary objective
of this chapter is to provide a sense of the richness of the financial marketplace, the critical role that it plays in
each of our lives, and the ways in which corporations use it to raise capital.
51
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P ART 1 | Introduction to Financial Management
Regardless of Your Major…
you start your first job after graduatDefined Benefit vs. When
ing, your employer will probably give you
Defined Contribution the option of automatically investing part
of your paycheck each pay period for your
Retirement Plans” retirement. Learning about the financial
“
markets will help you analyze your options
and make good selections. Twenty years ago, retirement plans were typically defined benefit
plans. You would work for only one company, and the company would reward your loyalty and
hard work by paying you a pension during your retirement based on your years of employment and
the level of pay that you earned. In other words, the company set aside money to pay your pension
benefit and invested it for you. Today, people change jobs often, and pension plans like the one
just described are very rare. Instead, most employers now offer their employees defined contribution plans, such as 401(k) savings plans in the United States, USS in the United Kingdom,
Riester pension in Germany, and Kiwisaver in New Zealand. With a defined contribution pension
plan, you, the employee, and your employer make periodic cash contributions to your retirement
fund, and you must take responsibility for investing these contributions. It doesn’t matter whether
you’re a doctor, lawyer, truck driver, or salesperson—you are going to be a pension fund manager.
Your Turn: See Study Question 2–1.
2.1
The Basic Structure of Financial
Markets
In Chapter 1, we showed that businesses typically opt to take on the form of a corporation
when they need to raise large amounts of capital. In this chapter, we will demonstrate how a
corporation raises capital using financial markets or financial intermediation in general.
As discussed in Chapter 1, a financial market is any place where money and credit are
exchanged. When you take out a home loan from your bank, you participate in the financial
markets. Within the financial markets, the following principal sets of players that interact:
1. Borrowers. Those who need money to finance their purchases. These include businesses
that need money to finance their investments or to expand their inventories as well as
individuals who borrow money to purchase a new automobile or a new home.
2. Savers (Investors). Those who have money to invest. These are principally individuals
who save money for a variety of reasons, such as accumulating a down payment for a home
or saving for a return to graduate school. Firms also save when they have excess cash.
3. Traders and Speculators. Those who borrow and invest with the sole purpose of making profits from the market. They act as both borrowers and savers in the market but their
borrowing is not intended to fund a business and neither is their investment based on savings siphoned out of a commercial activity. Just like regular borrowers and savers, traders
and speculators bring liquidity and efficiency in the market.
4. Financial Institutions (Intermediaries). The financial institutions and markets that help
bring borrowers and savers together. The financial institution you are probably most familiar with is the commercial bank, a financial institution that accepts deposits and
makes loans, such as HSBC, Halifax, Barclays, or Citibank, where you might have a
savings account. However, as we discuss in the next section, there are many other types
of financial institutions that bring together borrowers and savers.
Through these principle agents, financial markets deliver the function of financial intermediation, the process through which a financial instrument is exchanged for funds. For example,
banks extend loans in exchange for a loan contract signed by the recipient. In essence, financial intermediation involves one party to transfer funds while the other party signs (or agrees)
to a contract to repay through cash payments in future. The future cash payments, in turn, may
be subject to various types of risks. For example, if a firm borrows money from the bank, the
repayment schedule is defined in precise terms. On the other hand, when an investor invests in
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CHAPTER 2 | Firms and the Financial Markets
53
Figure 2.1
Financial Markets, Institutions, and the Circle of Money
The financial markets consist of institutions that facilitate the transfer of savings from individuals and firms that have excess cash to borrowers that have less cash than they need.
$ Financing
Repaid
FINANCIAL MARKETS
Saver
(Investor)
exchanges
cash for
financial
instruments.
Securities Markets
• Debt markets
• Stock markets
Borrower
Financial Marketplace
$ Financing
Obtained
Financial Institutions (Intermediaries)
• Commercial banks
• Finance companies
• Insurance companies
• Investment banks
• Investment companies
a firm’s shares, the returns are dependent on the dividend and any appreciation in the market
value of the shares, both of which are subject to change over time and may even lead to negative returns. The inherent risk also influences the returns expected by the provider of funds.
The relationship between risk and return is one of the primary areas of financial management
and is explored in later chapters.
2.2
he Financial Marketplace:
T
Financial Institutions
The financial markets facilitate the movement of money from savers, who tend to be individuals, to borrowers, who tend to be businesses. In return for the use of the savers’ money, the
borrowers provide the savers with a return on their investment.
As shown in Figure 2.1, the institutions that make up the financial marketplace consist of
commercial banks, finance companies, insurance companies, investment banks, and investment
companies. We call these institutions that help bring together individuals and businesses financial
intermediaries because these institutions stand between those that have money to invest and those
that need money. Financial markets are often described by the maturities of the securities traded in
them. For example, the money markets are markets for short-term debt instruments, with shortterm meaning maturities of one year or less. On the other hand, capital markets are markets for
long-term financial instruments, with long-term meaning maturities that extend beyond one year.
There are no national boundaries on financial markets. A borrower in Brazil, for example,
might borrow money from a bank in London to finance a plant expansion. Furthermore, it’s
not just individuals and companies that raise money and invest in the global financial markets.
Governments can enter the financial markets when they are experiencing a deficit and need
to raise money to finance their expenditures. Governments can also enter the financial markets when they have more money than they plan to spend and want to invest the surplus. For
example, the Chinese government has invested huge sums of money in U.S. Treasury bonds,
which are long-term debt securities issued by the U.S. government.
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P ART 1 | Introduction to Financial Management
Table 2.1
en Largest Commercial Banks in the World at the End of the First Quarter
T
of 2020
Commercial banks are ranked by the total dollar value of their assets. Most large banks are owned
by holding companies, which are companies that own other types of businesses in addition to the
bank. However, regulators across the world restrict the type of businesses that can be owned by
such holding companies.
Institution Name
Headquarters
Total Assets
(US$ in billions)
Industrial and C
­ ommercial Bank of
China (ICBC)
China
4,324.27
China Construction Bank Corp.
China
3,653.11
Agricultural Bank of China Ltd.
China
3,572.98
Bank of China Ltd.
China
3,270.15
Mitsubishi UFJ ­Financial Group Inc.
Japan
2,892.97
HSBC Holdings PLC.
United Kingdom
2,715.15
JP Morgan Chase and Co.
United States
2,687.38
Bank of America Corp.
United States
2,434.08
BNP Paribas SA.
France
2,429.26
Credit Agricole Group
France
2,256.72
Source: https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/
the-world-s-100-largest-banks-2020-57854079.
Commercial Banks: Everyone’s Financial Marketplace
As previously mentioned, the commercial bank is probably the first financial intermediary
each of us has dealt with in the financial marketplace. And, because they provide many firms
with their initial funding, commercial banks also tend to be one of the first financial intermediaries that businesses deal with. Banks collect the savings of individuals as well as businesses
and then lend these pooled savings to other individuals and businesses. They make money by
charging a rate of interest to borrowers that exceeds the rate they pay to savers.
Commercial banks are also one of the major lenders to businesses. However, in the
United States, although banks can loan money to industrial corporations, banks are prohibited
by law from owning them. This restriction prevents banks from loaning money to industrial
firms that they own; however, this restriction is not universal around the world. For instance,
in Japan and Germany, banks are among the largest owners of industrial firms.
Table 2.1 lists the top 10 banks across the world and their total assets. It is very possible
that that you will recognize your personal bank on this list because they operate across most
of the world. Even if you do not recognize these names, chances are that one or more of these
banking groups own most or part of the bank you deal with, directly or indirectly. For example, HSBC holdings operates at least 22 different banks across the world1.
Nonbank Financial Intermediaries
In addition to commercial banks, there are a number of highly specialized financial intermediaries that provide financial services to businesses. These include
• financial services corporations, such as GE Capital, a division of General Electric (GE),
and CIT Group, Inc. (CIT);
• insurance companies, such as American International Group, Inc. (AIG), and Prudential (PRU);
• investment banks, such as Goldman Sachs (GS) and Morgan Stanley (MS); and
• investment companies, including mutual funds, hedge funds, and private equity firms.
1
https://www.hsbc.com/investors/investing-in-hsbc/group-structure
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55
Financial Services Corporations
Perhaps the best-known financial services corporation in the world is GE Capital. For years,
it was the finance unit of GE, but in 2015, GE announced that it would be selling off most of
GE Capital over the following two years. GE Capital provides commercial loans, financing
programs, commercial insurance, equipment leasing of every kind, and other services in over
35 countries around the world. It also provides credit services to more than 130 million customers, including consumers, retailers, auto dealers, and mortgage lenders, offering products
and services ranging from credit cards to debt consolidation to home equity loans. CIT Group,
Inc., is another commercial finance company that offers a wide range of financing services to
businesses. The important thing to note here is that although financial services corporations
are in the lending or financing business, they are not commercial banks.
Insurance Companies
Insurance companies are by definition in the business of selling insurance to individuals and
businesses to protect their investments. This means that they collect premiums, hold the premiums in reserves until there are insured losses, and then pay out claims to the holders of the
insurance contracts. Note that in the course of collecting and holding premiums, the insurance
companies build up huge pools of reserves to pay future claims. They then use these reserves
to make various types of investments, including loans to individuals and businesses. American
International Group, Inc. (AIG), is now a household name because of the debt market crisis of
2008 and the ensuing government bailout. However, the company’s business activities serve
as an example of the degree to which insurance companies have become involved in business
finance. AIG not only sells insurance products but also provides financial services, including
aircraft and equipment leasing, consumer finance, insurance premium financing, and debt and
loan insurance. Of particular note in this listing of services is debt and loan insurance, which
includes selling guarantees to lenders that reimburse them if the loans they make go into default. This type of transaction is called a credit default swap, and we will have more to say
about this in Chapter 20, where we discuss risk management.
Investment Banks
Investment banks are specialized financial intermediaries that help companies and governments
raise money and that provide advisory services to client firms when they enter into major transactions such as buying or merging with other firms. When we look at raising funds in Chapter 9,
we will take an in-depth look at investment banking. Prominent firms that provide investment
banking services include Bank of America, Merrill Lynch, Barclays, Citigroup, Credit Suisse,
Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase, Morgan Stanley, and UBS AG.
Investment Companies
Investment companies are financial institutions that pool the savings of individual savers
and use the money to purchase other companies’ securities purely for investment purposes.
Mutual Funds and Exchange-Traded Funds (ETFs)
Perhaps the most widely known type of investment company is the mutual fund, a special
type of intermediary through which individuals can invest in virtually all of the securities
offered in the financial markets.2 When individuals invest in a mutual fund, they receive
shares in a fund that is professionally managed according to a stated investment objective or
goal—for example, investing only in international stocks. A share in the mutual fund grants
an ownership claim to a proportion of the mutual fund’s portfolio.
A share in a mutual fund is not really like a share of stock because you can directly buy
and sell shares in the mutual fund only from the mutual fund itself. The price that you pay
when you buy your shares and the price that you receive when you sell your shares are called
the mutual fund’s net asset value (NAV), which is calculated daily based on the total value
of the fund divided by the number of mutual fund shares outstanding. In effect, as the value of
the mutual fund investments goes up, so does the price of the mutual fund’s shares.
Mutual funds can either be load or no-load funds. A load fund is a mutual fund that is
sold through a broker, financial advisor, or financial planner who earns a commission in the
form of the load fee when he or she sells shares of the mutual fund. The term load refers to the
2
For a more in-depth discussion of mutual funds, go to http://www.sec.gov/answers/mutfund.htm.
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Finance for Life
Planning for Retirement
People tend to postpone their retirement planning for years,
often until the employers or regulators force them to do so. They
also tend to save too little in the early years of employment. Humans have a natural tendency to postpone immediate small sacrifices that will result into big rewards in future—at times too late to
make any difference. This is referred to as “instant gratification” in
psychology and has become a popular theory explaining decision
making related to factors like health, wealth, and social life3.
For your personal finance objectives, saving for your retirement
or for buying your first luxury car, the length of time that you save is
as important as the amount that you save to achieve your objective.
For example, let’s assume that Yuan Li and Jack Monroe join
an accounting firm as trainees straight after a degree in finance from
their local university. Over a period of next 30 years they both grew
to be partners in the firm, substantially increasing their take home
earnings. Yuan started contributing to a fixed income debt fund
from the very beginning paying a modest £292 a month for the
entire 30 years. Jack on the other hand decided to tick off everything on his bucket list first and then started to save after the first 15
years. However, he saved £750 a month for the remaining period of
15 years, a monthly saving amount that is two and a half times more
than Yuan. Assuming that the fixed income fund provided a fixed
income of 3 percent on average every year, and the interest is compounded monthly, the total value of Jack’s investments at the time
of their retirement will be £170,655.09. Yuan on the other hand will
get £170,584.57—almost the same amount. However, Yuan has
sacrificed only £105,120 (£292 a month for 30 years), while Jack
has to sacrifice £135,000 (£750 a month for 15 years) to receive
almost the same amount of value at their retirement. The difference
in returns at the end of period will be even more dramatic in countries with higher interest rates. For example in India fixed income
securities can easily return around 8 percent. At that rate Jack
will get £261,258.86 while Yuan will receive a substantial sum of
£438,086.19. The compounding effect over longer periods is very
substantial in determining total compound value of investments.
Your Turn: See Study Question 2–9.
sales commission you pay when acquiring ownership shares. These commissions can be quite
large; typically, they are in the 3.0 to 6.0 percent range, but in some cases, they can run as high
as 8.5 percent. A mutual fund that doesn’t charge a commission is referred to as a no-load
fund. When you purchase a no-load mutual fund, you generally don’t deal with a broker
or advisor. Instead, you deal directly with the mutual fund investment company via its website, by direct mail, or through a toll-free telephone number.
An exchange-traded fund (ETF) is very much like a mutual fund except for the fact that
the ownership shares in the ETF can be bought and sold on the stock exchanges throughout
the day. Most ETFs track an index, such as the Dow Jones Industrial Average or the S&P 500,
and generally have relatively low expenses.
Mutual funds and ETFs provide a cost-effective way to diversify, which reduces risk—a great
benefit for the small investor. If you have only $10,000 to invest, it is difficult to diversify by purchasing shares of individual companies because you have to pay a brokerage commission for each
individual stock you purchase. For example, buying 50 different stocks is likely to cost you $500
or more in commissions, which is 5 percent of the amount you are investing. By buying a mutual
fund or ETF, you can indirectly purchase a portfolio of 50 or more stocks with just one transaction.
Hedge Funds
A hedge fund is very much like a mutual fund, but hedge funds are less regulated and tend
to take more risk. They also tend to more actively influence the managers of the corporations
that they invest in. Because of the higher risk, hedge funds are open to a limited range of investors who are deemed to be sufficiently savvy. Only an accredited investor, which means
an individual with a net worth that exceeds $1 million, can invest in a hedge fund.
Management fees are also quite a bit higher for hedge funds; they typically run at about
2 percent of the assets and include an incentive fee (typically 20 percent of profits) based on
the fund’s overall performance.
3
This is a relatively new area of financial theory known as “Behavioural Finance.” If you are interested you can refer a
book called “Nudge – Improving decisions about health, wealth and happiness” by Richard Thaler and Cass Sunstein.
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Private Equity Firms
A private equity firm is a financial intermediary that invests in equities that are not traded on
the public capital markets. Two types of private equity firms dominate this group: venture capital
(VC) firms and leveraged buyout (LBO) firms. Venture capital firms raise money from investors
(wealthy people and other financial institutions), which they then use to provide the initial financing
for private start-up companies. For example, Sevin Rosen Funds, established in 1980, has provided
venture financing to Cypress Semiconductor (CY) and Silicon Graphics (SGIC). Kleiner Perkins
Caufield & Byers—or KPCB, as it is commonly called—is a VC firm located in Silicon Valley. It
is perhaps best known today for its involvement in the initial financing of Google (GOOG). It has
also partnered with Apple (AAPL) to found the iFund™, a $100 million investment initiative that
will fund market-changing ideas and products that extend the iPhone and iPod Touch platform.
The second major category of private equity firms is the leveraged buyout firm. These firms
acquire established companies that typically have not been performing very well with the objective
of making them profitable again and then selling them. LBO firms have been the subject of a number of popular movies, including Barbarians at the Gate, Other People’s Money, and Wall Street.
Prominent LBO private equity firms include Cerberus Capital Management, L.P., which
purchased Chrysler Corporation from Daimler Benz, and TPG (formerly Texas Pacific
Group), which has invested in a number of prominent firms, including Continental Airlines
(CAL), Ducati (DMH.BE), Neiman Marcus, Burger King (BKC), MGM (MGM), Harrah’s
(HAG.HM), and Freescale Semiconductor (FSL-B). A third well-known LBO private equity
firm is KKR (Kohlberg, Kravis, and Roberts), whose investment in the likes of RJR Nabisco
provided the storyline for Barbarians at the Gate.
The amount of money managed by private equity firms has grown dramatically over
the last three decades, with new funds raised totaling around a half a trillion dollars in 2014.
Three-quarters of the total is raised in North America; the majority of the remainder is raised
in Europe. Of the total amount of money managed by private equity firms, roughly two-thirds
is invested in the buyout or LBO category. In fact, LBO transactions grew from $7.5 billion in
1991 to $500 billion in 2006! But as you might expect, the number of deals dropped dramatically in the fourth quarter of 2008 and in 2009, and it is still not up to the 2006 level. However,
the dollar amount of capital invested by private equity intermediaries understates their importance to the economy. Private equity funding is largely responsible for financing the birth of
new businesses and underwriting the renovation of old and faltering businesses.
Before you move on to 2.3
Concept Check | 2.2
1. Explain how individuals and firms use financial intermediaries to raise money in the financial markets.
2. How do commercial banks differ from other, nonbank financial intermediaries?
3. What are examples of investment companies?
4. What is a hedge fund, and how does it differ from a mutual fund?
5. What are the two principal types of private equity firms?
2.3
The Financial Marketplace:
Securities Markets
A security is a negotiable instrument that represents a financial claim. It can take the form of
ownership (stock) or a debt agreement (bond). Businesses and individual investors can trade
the securities issued by public corporations—that is, those whose debt and equity are traded in
the public securities markets. Securities markets are typically discussed in terms of the primary
and secondary markets. A primary market is a market in which new, as opposed to previously
issued, securities are bought and sold for the first time. In this market, firms issue new securities
to raise money that they can then use to help finance their businesses. The key feature of the
primary market is that the firms selling securities actually receive the money raised.
The secondary market is where all subsequent trading of previously issued securities
takes place. In this market, the issuing firm does not receive any new financing, as the
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Figure 2.2
Security Markets Provide a Link Between the Corporation and Investors
Step 1: Initially, the corporation raises funds in the financial markets by selling securities (a primary
market transaction). Step 2: The corporation then invests this cash in return-generating assets—
new projects. Step 3: The cash flow from these assets is reinvested in the corporation, given back
to the investors, or paid to the government in the form of taxes. Step 4: Immediately after the securities have been issued, they are traded among investors in the secondary market, thereby setting
their market price.
Primary Market
Step 1: Securities are sold for cash
Corporation
Investors
Cash
Securities
Step 2:
The corporation
invests in returngenerating assets
Cash reinvested
in the corporation
Cash flow from
operations
Step 3:
Cash distributed
back to investors
Step 4: Securities
are traded among
investors in the
secondary market
Taxes
Government
securities it has sold are simply being transferred from one investor to another. The principal
benefit of the secondary market for the shareholders of firms that sell their securities to the
public is liquidity. That is, if you purchased some of the shares of Netflix when it went public
in 2002, you could easily sell those shares in the secondary market if you decided you no longer wanted to hold them. This ability to sell when you want to means that your Netflix stock
is a very liquid investment. As a result of this liquidity, investors are more willing to invest in
these securities, which benefits the issuing firms.
How Securities Markets Bring Corporations
and Investors Together
Figure 2.2 describes the role of the securities markets in bringing investors together with businesses looking for financing. In this regard, the securities markets are just another component
of the financial marketplace. They are unique, however, in that investors in the securities
markets provide money directly to the firms that need it, as opposed to making deposits in
commercial banks that then loan money to those firms.
We can think of the process of raising money in the securities markets in terms of the four
steps highlighted in Figure 2.2:
Step 1. The firm sells securities to investors. The firm raises money in the securities markets by selling either debt or equity. When it initially sells the securities to the public,
the sale is considered to take place in the primary market. This is the only time the
firm receives money in return for its securities.
Step 2. The firm invests the funds it raises in its business. The firm invests the cash raised
in the securities markets in hopes that it will generate cash flows—for example, it may
invest in a new restaurant, a new hotel, a factory expansion, or a new product line.
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59
Step 3. The firm distributes the cash earned from its investments. The cash flow from
the firm’s investments is reinvested in the firm, paid to the government in taxes, or
distributed to the investors who own the securities issued in step 1. In the last case,
the cash is distributed to the investors who loaned the firm money (that is, bought
the firm’s debt securities) through the payment of interest and principal. Cash is
distributed to the investors who bought equity (stock) through the payment of cash
dividends or the repurchase of shares of the firm’s previously issued stock.
Step 4. The firm’s securities are traded in the secondary market. Immediately after the
firm’s securities are sold to the public, the investors who purchased them are free to
resell them to other investors. These subsequent transactions take place in the secondary market.
Types of Securities
If you read the financial section of your newspaper or watch financial TV channels such as
CNBC, you are already aware of the wide variety of investment alternatives to choose from.
These choices fall into one of two basic categories: debt and equity.
Debt Securities
Firms borrow money by selling debt securities in the debt market. If the debt must be repaid
in less than a year, these securities are sold in the short-term debt market, also called the money
market. If the debt has a maturity (the length of time until the debt is due) of between 1 and
10 years, it is often referred to as a note, and if the maturity is longer than 10 years, it is called
a bond; both are sold in the capital market, which is the market for long-term financial instruments. The vast majority of these bonds pay a fixed interest rate, which means that the interest
the owner of the bond receives never changes over its lifetime. Bonds are generally described
using fairly exotic terminology. For example, we might say that a bond has a face value or par
value of $1,000 and that it pays an 8 percent coupon rate with two payments per year. What this
means is that when the bond matures and the issuer (borrower) has to repay it, the owner of the
bond (the lender) will receive a payment of $1,000. In the meantime, the owner will receive an
interest payment every six months equal to $40, or $80 per year, which is 8 percent of $1,000.
Equity Securities
Equity securities represent ownership of the corporation. There are two major types of
equity securities: common stock and preferred stock. When you buy equity securities, you are
making an investment that you expect will generate a return. However, unlike a bond, which
provides a promised set of interest payments and a schedule for the repayment of principal, an
equity security provides returns that are less certain. To further explore this topic, let’s take a
brief look at both types of equity securities.
Common Stock
Common stock is a security that represents equity ownership in a corporation, provides voting
rights, and entitles the holder to a share of the company’s success in the form of dividends and
any capital appreciation in the value of the security. Investors who purchase common stock are
the residual owners of the firm. This means that the common stockholders’ returns are earned
only after all other security-holder claims (debt and preferred equity) have been satisfied in full.
If you purchase 100 shares of Disney’s common stock, you are a part-owner in the
company. In essence, you own an interest in the firm’s studios, a piece of its movies, and
a piece of its theme parks, including the new park in Shanghai. The more shares you buy,
the bigger the portion of Disney you own. What do you get as an owner of Disney’s stock?
Don’t count on free tickets to Disney World or a copy of the latest Star Wars movie. As an
owner of the firm, you have voting rights that entitle you to vote for the members of the
firm’s board of directors, who, in turn, oversee the selection of the management team. But as
a small-time investor, you have limited voting rights—your 100 shares of Disney’s stock are
about 0.00000617 percent of Disney’s shares. Thus, you aren’t going to have much say about
who gets elected to the Disney board of directors. Nonetheless, if Disney earns a profit, you
will probably receive a portion of those profits in the form of a dividend payment. It should
be noted that firms that sell bonds must make bond payments, but firms that sell stock don’t
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have to pay dividends. For example, if a company needs money to invest in a new product or
project, it can choose to retain all of its earnings within the firm and pay no dividends.
Generally, firms that earn higher profits can pay higher dividends, and this often means
that investors place a higher value on that firm’s stock. For example, in 1999 the stock price
of Qualcomm, a high-tech communications firm, went up 2,621 percent! However, when
Qualcomm’s profits and dividends, and people’s expectations about its future prospects,
deteriorated, its stock price fell by 50 percent in 2000, by another 26 percent in 2001, and then
by another 30 percent in 2002. Since the end of 2002, there have been ups and downs, but by
early 2006, the price of Qualcomm had risen over three-fold from its 2003 level. This all goes
to show that stock prices can fluctuate dramatically.
Preferred Stock
Preferred stock, like common stock, is an equity security. However, as the name implies, preferred stockholders take a “preferred” position relative to common shareholders. This means
that preferred shareholders receive their dividends before any dividends are distributed to the
common stockholders, who receive their dividends from whatever is left over. Note, however,
that if the company does not earn enough to pay its interest expenses, neither preferred nor
common stockholders will be paid a dividend. However, the dividends promised to the preferred stockholders will generally accrue and must be paid in full before common shareholders
can receive any dividends. This feature is oftentimes referred to as a cumulative feature, and
preferred stock with this feature is often referred to as cumulative preferred stock. In addition,
preferred stockholders have a preferred claim on the distribution of assets of the firm in the
event that the firm goes bankrupt and sells or liquidates its assets. Very simply, the firm’s
creditors (bondholders) get paid first, followed by the preferred stockholders, and anything
left goes to the common stockholders. Of interest is that not all firms issue preferred stock.
Preferred stocks are also used by some governments to retain control over private companies within selected groups. For example, company laws in China allow firms to issue different
types of shares, each type with different ownership claim and features. For example, Type
A shares can only be traded by Chinese residents or authorized investors, Type B shares are
traded and priced in US dollars and also allow investments from non-residents4.
Preferred stock is sometimes referred to as a hybrid security because it has many characteristics of both common stock and bonds. Preferred stock is similar to common stock in that
(a) it has no fixed maturity date, (b) the nonpayment of dividends does not bring on bankruptcy for the firm, and (c) the dividends paid on preferred stock are not deductible for tax
purposes. However, preferred stock is similar to corporate bonds in that (a) the dividends paid
on preferred stock, like the interest payments made on bonds, are typically a fixed amount and
(b) preferred stock does not come with any voting rights.
Stock Markets
A stock market is a public market in which the stock of companies is traded. Traditionally,
stock markets are classified as either organized security exchanges or the over-the-counter
market. The over-the-counter market is an informal, electronic network where approximately 35,000 securities not traded on the major exchanges are bought and sold. In the United
States, the largest public market is the New York Stock Exchange (NYSE), whose history is
traced back to 1792. Because it occupies a physical space (it is located at 11 Wall Street in
Manhattan), it is considered an organized security exchange. The common stock of more than
2,800 listed companies is traded on this exchange, which has a monthly trading volume that
exceeds 20 billion shares! In addition, the total value of the shares of stock listed on the NYSE
at the beginning of 2016 was just under $20 trillion.
Today, the mechanics of trading have changed dramatically, and 80 to 90 percent of
all trades are done electronically. Even if your stock is listed on an organized exchange like
the NYSE, the odds are that its transactions won’t be executed on the floor of that exchange
but rather will be executed electronically in the maze of computers that make up the global
trading network. In effect, there is now little difference in how a security is traded between
an organized exchange and the over-the-counter market. However, the NYSE remains a hybrid market, allowing for face-to-face trading between individuals on the floor of the stock
4
FTSE Russel research group has a very good guide for Chinese share classes: https://research.ftserussell.com/­
products/downloads/Guide_to_Chinese_Share_Classes.pdf
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61
Figure 2.3
Common Stock Price Quotes
The following is typical of what you would see if you looked at www.google.com/finance.
Stock Price and
Change from
Previous Day: For
Disney, the current
price is $98.78,
which represents an
increase of 0.03% or
$0.03 from the
previous day’s
closing price.
Name and Symbol:
These are used to
identify the stock.
For example, the
symbol for Disney is
“DIS.” You can also
use the stock’s
symbol when using
online systems to
look up information
on the stock.
Open, High,
and Low: On
this day,
Disney’s stock
price opened the
day at $98.96,
and ranged
between a high
of $99.12 and a
low of $98.46.
Mkt Cap:
Market Cap
refers to the
total value of
all the
company’s
common
stock
outstanding.
52Wk High and
52Wk Low: These are
the highest and lowest
prices paid for the
stock over the past
52 weeks, excluding
the latest day’s trading.
These prices will give
you a sense of the
direction the stock
price is taking–
whether its price is
generally going up or
down and by how
much.
The Walt Disney Company (Public, NYSE: DIS)
98.78
+0.03(0.03%)
Real-time: 12:52PM EDT
Vol and Avg. Vol:
Vol represents the
number, or
volume, of shares
of stock that were
traded so far
during the day,
while Avg. Vol
represents the
average volume on
a typical day.
Open: 98.96
High: 99.12
Low:
98.46
Volume: 3.14M
Mkt Cap:
160.3B
52Wk High: 122.06
52Wk Low: 98.46
Avg Vol:
8.73M
P/E, F P/E: P/E stands for price-earnings ratio (P/E
ratio, also called the “earnings multiple”). The P/E ratio is
the stock’s price divided by the income, or profit,
earned by the firm on a per-share basis over the
previous 12 months. In effect, it states the multiple that
investors are willing to pay for one dollar of earnings.
High P/Es may result as investors are willing to pay
more for a dollar of earnings because they believe that
earnings will grow dramatically in the future. Low P/Es
are generally interpreted as an indication of poor or
risky future prospects. F P/E is the forward
price-earnings ratio, and uses estimated earnings over
next 12 months. If there is no estimate, it is not given.
P/E:
FP/E:
Beta:
EPS:
18.19
15.96
1.05
5.43
EPS:
The
earnings
per
share.
Dividend: 0.71
Yield:
1.44
Shares:
1.62B
Inst. Own: 68%
Beta: A
measure of the
relationship
between an
investment’s
returns and
the market’s
returns. It will
be discussed in
detail later.
Dividend and Yield:
Dividend is the stock's
annual cash dividend, while
Yield is the dividend yield,
which is obtained by
dividing the firm's annual
cash dividend by the closing
price of the stock that day.
Shares, Inst. Own:
Shares represents
number of shares
outstanding while
Inst. Own identifies
the percent of the
shares outstanding
that are owned by
institutions such as
mutual funds and
institutional
ownership.
exchange in addition to automated electronic trading. As a result, during times of extreme flux
in the market, at the opening or close of the market, or on large trades, human judgment can
be called on to make sure that the trade is properly executed.
The NASDAQ, which stands for National Association of Securities Dealers Automated
Quotations, was formed in 1971 and is actually home to the securities of more companies than the
NYSE. In 2016, some 3,100 companies were listed on the NASDAQ, after having reached a peak
of 5,556 in 1996. It has become highly popular as the trading mechanism of choice of several fastgrowth sectors in the United States, including the high-technology sector. The common stock of
computer chip maker Intel (INTC), for example, is traded via the NASDAQ exchange, as is that
of Dell (DELL), Starbucks (SBUX), Whole Foods Market (WFM), and Alphabet (GOOG).
Reading Stock Price Quotes
Figure 2.3 illustrates how to read stock price quotes from www.google.com/finance. This is
just a bit of the information available on each firm listed on Google Finance. You’ll also find
stock price charts, news items, Internet discussions, information on related companies, and
analyst estimates, along with the firm’s financial statements and key statistics and ratios. Similar information is given by Yahoo Finance (finance.yahoo.com) and the Wall Street Journal
Online (www.wsj.com under Markets at the top of the page, click on “Market Data” and “U.S.
Stocks” to reach “Market Data Center”).
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Table 2.2
Characteristics of Different Financial Instruments
Money Market
Debt
For the Borrower:
• Good way of inexpensively raising money for short periods of time.
• Rates tend to be lower than long-term rates.
• Can borrow money to match short-term needs.
• If interest rates rise, the cost of borrowing will immediately rise accordingly.
For the Investor:
• Very liquid—investors have access to their money when they need it.
• Safe—generally invested in high-quality investments for brief periods.
• Low returns—rates tend to be close to the rate of inflation.
Instrument
Country
Major Participants
Riskiness
Original Maturity
Interest Rates
Treasury Bills
United
States,
United
Kingdom
Issued by the U.S.
­Treasury, investors are
large businesses and banks
Virtually default free
4 weeks to 1 year
0.10% to 0.18%5
Treasury Bills
(T-Bills)
Singapore
Issued by the ­government
of Singapore, retail
­investors are also allowed
to buy directly
Virtually default free
6 months or 1 year
0.12%6
Commercial
paper and Eurocommercial
paper
United
States,
Europe
Issued by financially
secure firms to fund
­operating expenses
or current assets like
­inventories or receivables
Low default risk
Up to 270 days
1.5% to 3.8%7
Negotiable
Certificate of
Deposit (CDs)
United
States,
United
Kingdom,
other
countries
Issued by commercial
banks to large investors,
minimum denomination
is $100,000 or £100,000
Default risk linked to
issuing bank’s status
2 weeks to 1 year
in the United
States, up to
5 years in the
United Kingdom
0.11% to 2.11%8
Money market
mutual funds
(US) and Fixed
income mutual
fund (UK)
United
Kingdom,
United
States,
and other
countries
Issued by mutual funds
and invested in debt
­obligations such as
­treasury bills, CDs,
GILTS, etc.
Low degree of risk
No specific maturity date
Dependent on the
investments made
by the fund manager
Consumer
credit, including
credit card debt
All over
the world
Nonmortgage consumer
debts issued by banks,
credit unions, and finance
companies
Risk is variable
Varies
Variable, depending
on the risk level
Long-Term
Debt and
Fixed Income
Securities
For the Borrower:
• Interest rates are locked in over the entire life of the debt.
• Has a tax advantage over common stock in that interest payments are tax deductible, whereas dividend payments are not.
For the Investor:
• Can be used to generate dependable current income.
• Some bonds produce tax-free income.
• Long-term debt tends to produce higher returns than short-term debt.
• Less risky than common stock.
• Investors can lock in an interest rate and know the future returns (assuming the issuer does not default on its
payments).
5
https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=billrates
https://www.mas.gov.sg/bonds-and-bills/auctions-and-issuance-calendar/Auction-T-bill?issue_code=BS20109S&issue_date=2020-05-19
7
https://www.ft.com/content/326d5e19-8f48-422d-977d-d10f30295a78
8
https://www.investopedia.com/best-cd-rates-4770214
6
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CHAPTER 2 | Firms and the Financial Markets
Table 2.2
63
Characteristics of Different Financial Instruments continued
Instrument
Country
Major Participants
Riskiness
Original Maturity
Interest Rates*
Government
­Issued Long
Term Stocks
(GILTS)
United
Kingdom
Issued by HM Treasury
Virtually default free, but
price varies with changes
in market interest rates
5, 10, or 30 years
0.125% to 0.5%9
U.S. Treasury
notes and bonds
United
States
Issued by the U.S. government to a range of
investors
No default risk but price
varies with change in
market interest rate
Notes—2, 5, and
10 years; bonds—
greater than
10 years
0.13% to 1.46%
Mortgages,
home loans
All
countries
Borrowings from
­commercial banks,
co-operative banks, and
other type of financing
firms
Risk is variable, subprime mortgages have a
great deal of risk
20 to 30 years, but
with wide variation
(Sweden can go up
to 105 years)
Wide range,
­depending on the
country (UK ­average
is 2.35% while India
average is 8%)
Municipal
bonds (state and
local government bonds
All over
the world
with some
variation
Issued by state and local
governments to individuals, institutions, and foreign investors
Riskier than GILTS and
central government issued bonds but allows
tax exemption
Varies from a few
years to 100 years
(Century bonds in
Europe)
Wide range depending on the country
and local issuing
authority
Corporate
bonds
All over
the world
Issued by corporations to
individuals, corporations,
and institutional investors
Risk is dependent on
the status of the issuer.
Riskier than government bonds but less
risky than shares
Normally 5 to 20
years but may be
much longer (CocaCola have issued
100-year bonds)
Wide range depending on the country
and local issuing
firm
Preferred Stock
For the Issuer:
• Dividends can be omitted without the risk of bankruptcy.
• Has the disadvantage that dividends are not tax deductible for the issuer, whereas interest payments from debt
are tax deductible.
• Sometimes allows existing owners to retain control by issuing preference shares without voting rights or other
restrictions.
For the Investor:
• Some countries allow tax benefit for preferred stock. For example, in the United States, a minimum of
70 percent of dividends received are tax-free.
Instrument
Country
Major Participants
Riskiness
Original Maturity
Interest Rates*
Preferred stocks
United
States
Issued by corporations to
individuals, corporations,
and institutional investors
Riskier than debt instruments but less risky
than common stocks
No maturity date
Dependent on risk,
generally ranging
from 3% to 8%
Preference
shares
United
Kingdom
Issued by corporations to
individuals, corporations,
and institutional investors
Riskier than debt instruments but less risky
than common stocks
No maturity date
Pays a fixed amount
of dividend per
share
Common Stock
For the Issuer:
• The issuing firm is not legally obligated to make payments.
• Does not have a maturity date.
• Issuance of common stock increases creditworthiness because the firm has more investor money to cushion the
firm in the case of a loss.
For the Investor:
• Over the long run, common stock has outperformed debt-based financial assets.
• Along with the increased expected return comes increased risk.
Instrument
Country
Major Participants
Riskiness
Original Maturity
Interest Rates
Common stock,
ordinary shares
All over
the world
Issued by corporations to
individuals, corporations,
and institutional investors
Risky, with dividends
paid only when they are
declared
No maturity date
No interest or fixed
return
*All data for yield as on May 27, 2020.
9
https://www.dmo.gov.uk/data/pdfdatareport?reportCode=D1A
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PART 1 | Introduction to Financial Management
Finance in a Flat World
Where’s the Money Around the World
United States
Russia
Norway
Finland
England
Sweden
Denmark
Germany
France
Spain
Italy Turkey
Morocco
North Africa
USA
Mexico
Asia
China
20.2
Japan
South Korea
France
16.0
Philippines
Germany
14.7
Latin America
Brazil
South Africa
36.1
United Kingdom
Thailand
Malaysia
Argentina
72.7
Australia
9.6
Canada
8.3
0
The figure above describes the total value of financial assets
(bonds, equities, and bank assets) in the financial markets for major countries and regions of the world at the end of 2013. Although
the totals change from year to year, these data provide some insight into how the value of financial assets is distributed around
10
20
30
40
50
$ Trillions
60
70
80
the world. When it comes to stock market capitalization—that is,
the value of all equities—the United States clearly dominates, being the home for about one-third of equities.
Source: International Monetary Fund, Global Financial Stability Report Statistical Appendix, April 2015, http://www.imf.org/external/pubs/ft/gfsr/2015/01/pdf/statapp.pdf.
Your Turn: See Study Question 2–10.
Other Financial Instruments
So far we have touched on only the tip of the iceberg in terms of the variety of different types
of financial instruments that are available to investors and firms. Table 2.2 provides a listing
of a number of different financial instruments used by firms to raise money, beginning with
the shortest-maturity instruments, which are traded in the money market, and moving through
the longest-maturity securities, which are traded in the capital market.
The Financial Markets and the Financial Crisis
Beginning in 2007, the United States experienced its most severe financial crisis since the
Great Depression of the 1930s. As a result, some financial institutions collapsed, while the
government bailed others out; unemployment skyrocketed; the stock market plummeted; and
the country entered into a recession. Although the recession is now officially over, the U.S.
economy still faces the lingering effects of the financial crisis.
Although many factors contributed to the financial crisis, the most immediate cause has been
found to be the collapse of the real estate market and the resulting real estate loan (mortgage)
defaults—in particular, on what are commonly referred to as subprime mortgages. These were
loans made to borrowers whose ability to repay them was highly doubtful. When the market
for real estate began to falter in 2006, many of the home buyers with subprime mortgages
began to default. As the economy contracted during the recession, people lost their jobs and
could no longer make their mortgage loan payments, resulting in even more defaults.
To complicate the problem, most real estate mortgages were packaged in portfolios
and resold to investors around the world. This process of packaging mortgages is called
securitization because it takes loans, which cannot be publicly traded, and turns them into
securities that can be freely bought and sold by financial institutions. Here’s how mortgages
are securitized:
1. A home buyer borrows money by taking out a mortgage to finance a home purchase.
2. The lender—generally, the bank, savings and loan institution, or mortgage broker that
made the loan—then sells the mortgage to another firm or financial institution.
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CHAPTER 2 | Firms and the Financial Markets
65
3. That financial institution creates a portfolio of many different mortgages and finances the
purchase of that pool of mortgages through the sale of securities called mortgage-backed
securities (MBSs).
4. These MBSs are sold to investors, who can hold them as an investment or resell them to
other investors.
This process allows the bank or other financial institution that made the original mortgage
loan to get its money back out of the loan and lend it to someone else. Thus, securitization
provides liquidity to the mortgage market and makes it possible for banks to loan more money
to home buyers.
Okay, so what’s the catch? As long as lenders properly screen the mortgages to make sure
the borrowers are willing and able to repay their home loans and as long as real estate values
remain higher than the amounts owed, everything works fine. However, if the financial institution that originates the mortgage plans on selling it rather than holding it, it may have less incentive to properly screen the borrower. It all goes back to P Principle 5: Individuals Respond
to Incentives. Lenders made their money by making the loans and then selling them almost
immediately. As a result, some lenders were concerned only with making and selling the loan—
to them, whether or not the borrower could repay the loan was someone else’s problem.
Starting around 2006, when housing prices began to drop, homeowners began to default
on their mortgage loans. These defaults triggered losses at major banks, which, in turn, triggered a recession, causing people to lose their jobs and, correspondingly, the ability to make
their mortgage payments. This was the scenario that played out at least through 2009. In essence, this was a perfect storm of bad loans, falling housing prices, and a contracting economy.
Unfortunately, these problems did not stay in the United States. Banks in Europe also
held many of these MBSs, so defaults in the United States triggered a worldwide banking
crisis. On top of this, European banks held a lot of the European sovereign debt, so if countries
defaulted on their debt, the European banking system would be in trouble. The recession that
was originally sparked by the banking crisis revealed that the government budget situation
in countries such as Greece was unsustainable, leading to the current European debt crisis.
Today, many members of the European Union are experiencing severe economic and budget
problems; high unemployment, which was just under 25 percent in Greece and 21.4 percent
in Spain at the beginning of 2016; and the Syrian refugee crisis.
As a further result of the financial crisis, the stand-alone investment banking industry in
the United States is no more. From the time of George Washington until the Great Depression
in the 1930s, the U.S. economy experienced financial panics and banking crises about every
15 years. In response to the Great Depression and the failure of 4,004 banks in 1933, Congress
enacted the National Banking Act of 1933, several sections of which are commonly referred
to as the Glass–Steagall Act. An important component of the Glass–Steagall Act was the
separation of commercial banking and the investment industry. Specifically, the act prohibited commercial banks from entering the investment industry in order to limit risks to banks.
As a result, a stand-alone investment banking industry was created by firms like Lehman
Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley. However, in
1999 Glass–Steagall was repealed, and many commercial banks acquired investment banks,
whereas others, such as JPMorgan Chase & Co. (JPM), entered the investment banking business. The advantage of this combination was that it gave investment banks access to stable
funding through bank deposits, along with the ability to borrow from the Federal Reserve in
the case of an emergency, while commercial banks gained access to the more lucrative, albeit
more risky, investment industry.
In the wake of the 2008 financial crisis, the financial industry was again transformed.
During the crisis, the major stand-alone investment banks failed (Lehman Brothers), were
acquired by commercial banks (Bear Stearns and Merrill Lynch), or were converted to commercial banks (Morgan Stanley and Goldman Sachs). Indeed, by the end of 2008, there were
no major stand-alone investment banking firms left.
Then in 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act was
passed. Under Dodd–Frank, banks and nonbank financial institutions are subject to considerably more oversight and are required to be more transparent. Another important feature of this
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P ART 1 | Introduction to Financial Management
legislation is what is known as the Volker rule, which prohibits banks that take deposits from
engaging in proprietary trading—that is, using the bank’s capital to make speculative bets
on derivatives and securities.
The hope is that these changes will increase the stability of the U.S. financial system
and ensure that we will no longer be subject to financial crises that throw our economy into
a severe recession. However, critics have argued, on one hand, that the recent legislation has
not done enough to protect consumers or increase the safety of the financial system and, on
the other hand, that it adds unnecessary bureaucracy to our financial institutions.
Before you begin end of chapter material
Concept Check | 2.3
1. What are debt and equity securities, and how do they differ?
2. How is a primary market different from a secondary market?
C H A P T E R
2
3. How does common stock differ from preferred stock?
Applying the Principles of Finance to Chapter 2
P Principle 2: There Is a Risk-Return Tradeoff Financial markets are organized to offer investors a wide range of investment opportunities
that have different risks and different expected rates of return that reflect those
risks.
P Principle 5: Individuals Respond to Incentives One of the
reasons for the recent subprime mortgage crisis may have been the lack of
incentives to screen borrowers.
P Principle 4: Market Prices Reflect Information It is through
the operations of the financial markets that new information is efficiently impounded in security prices.
Chapter Summaries
2.1
Describe the structure and functions of
financial markets. (pg. 52)
SUMMARY: Financial markets allocate the supply of savings in the economy to the individuals
and companies that need the money. A primary market is a market in which new, as opposed to
previously issued, securities are bought and sold for the first time. In this market, firms issue new
securities to raise money, which they can then use to help finance their businesses. The key feature
of the primary market is that the firms that raise money by selling securities actually receive the
money.
The secondary market is where all subsequent trading of previously issued securities takes
place. In this market, the issuing firm does not receive any new financing, as the securities it has
sold are simply being transferred from one investor to another. The principal benefit to investors of
having a secondary market is the ease with which they can sell or liquidate investments.
KEY TERMS
Commercial bank, page 52 A financial
institution that accepts demand deposits,
makes loans, and provides other services to
the public.
Defined benefit plan, page 52 A company
retirement plan, such as a pension plan, in which
a retired employee receives a specific amount
M02_TITM9824_14_GE_C02.indd 66
based on his or her salary history and years of
service.
Defined contribution plan, page 52 A
company retirement plan, such as a 401(k) plan,
in which the employee elects to contribute some
amount of his or her salary to the plan and takes
responsibility for the investment decisions.
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CHAPTER 2 | Firms and the Financial Markets
2.2
67
Distinguish between commercial banks and other financial
institutions in the financial marketplace. (pgs. 52–57)
SUMMARY: Financial institutions are intermediaries that stand in the middle between borrowers who need money and savers who have money to invest. Widely varying financial institutions
have evolved over time to meet special needs for intermediation, including commercial banks,
which accept deposits from savers and lend to borrowers; investment banks, which help companies sell their securities to investors in order to raise the money they need; and many other
institutions. Of particular interest are mutual funds, which collect the investments of many small
investors and invest the pool of funds in stocks, bonds, and other types of securities that are issued by businesses. In recent years, two types of investment companies have captured the headlines: hedge funds and private equity funds. Both of these types of investment companies accept
investments from other financial institutions or wealthy individuals and invest in speculative and
risky ventures.
KEY TERMS
Accredited investor, page 56 An investor
who is permitted to invest in certain types of
higher-risk investments. Accredited investors include wealthy individuals, corporations, endowments, and retirement plans.
long-term financial instruments.
Credit default swap, page 55 An insurance
Load fund, page 55 A mutual fund that charges
contract that pays off in the case of a credit event
such as default or bankruptcy.
Money market, page 53 The financial mar-
Exchange-traded fund (ETF), page 56
1. Explain how individuals
and firms use financial
intermediaries to raise money in
the financial markets.
2. How do commercial banks
differ from other, nonbank
financial intermediaries?
3. What are examples of
investment companies?
4. What is a hedge fund, and
how does it differ from a mutual
fund?
5. What are the two principal
types of private equity firms?
M02_TITM9824_14_GE_C02.indd 67
vests the pooled funds of retail investors for a fee.
Leveraged buyout firm, page 57 A private
equity firm that raises capital from individual
investors and uses these funds, along with significant amounts of debt, to acquire controlling
interests in operating companies.
Capital market, page 53 The market for
Concept Check | 2.2
Investment company, page 55 A firm that in-
An investment vehicle traded on stock exchanges
much like a share of stock. The entity holds
investments in assets that meet the investment
objective of the entity (e.g., shares of stock of
companies from emerging markets).
Financial intermediaries, page 52 Institutions whose business is to bring individuals
and institutions with money to invest or lend
together with other firms or individuals in need
of money.
Hedge fund, page 56 An investment fund that
is open to a limited range of investors (accredited
investors) and that can undertake a wider range of
investment and trading activities than can other
types of investment funds that are open to the
general public (e.g., mutual funds).
Investment bank, page 55 A financial institution that raises capital, trades in securities, and
manages corporate mergers and acquisitions.
investors a sales commission called a load.
ket for short-term debt securities (maturing in one
year or less).
Mutual fund, page 55 A professionally managed investment company that pools the investments of many individuals and invests them in
stocks, bonds, and other types of securities.
Net asset value (NAV), page 55 For an entity such as a mutual fund, the difference between
the current market value of its assets and the
value of its liabilities.
No-load fund, page 55 A mutual fund that
doesn’t charge a commission.
Private equity firm, page 57 A financial
intermediary that invests in equities that are not
traded on the public capital markets.
Venture capital firm, page 57 An investment company that raises money from accredited
investors and uses the proceeds to invest in new
start-up companies.
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P ART 1 | Introduction to Financial Management
2.3
Describe the different securities markets for bonds
and stocks. (pgs. 57–65)
SUMMARY: When a corporation needs to raise large sums of money, it generally turns to the
public market for bonds if it borrows or the public market for equity if it seeks funds from new
owners. The buyers of these securities include individual investors and investment companies
such as mutual funds. The U.S. stock and bond markets are the largest and most active in the
world. Traditionally, stock markets are classified as either organized security exchanges or the
over-the-counter market, which is an informal, electronic network where approximately 35,000
securities not traded on the major exchanges are bought and sold. While organized markets have
physical locations where buyers and sellers interact, such as the New York Stock Exchange at
11 Wall Street, many trades on these exchanges take place electronically. Beginning in 2007, the
United States experienced its most severe financial crisis since the Great Depression of the 1930s.
Although there is not a single cause for the crisis, the collapse of the real estate market certainly
contributed to this event.
KEY TERMS
Bond, page 59 A long-term (10-year or more)
Over-the-counter market, page 60 An in-
promissory note issued by a borrower, promising
to pay the owner of the security a predetermined
amount of interest each year.
formal, electronic network where approximately
35,000 securities not traded on the major exchanges are bought and sold.
Common stock, page 59 A form of equity
Preferred stock, page 60 A form of equity
security that represents the residual ownership of
the firm.
security that holds preference over common stock
in terms of the right to the distribution of cash
(dividends) and the right to the distribution of
proceeds in the event of the liquidation and sale
of the issuing firm.
Coupon rate, page 59 The amount of interest
paid per year, expressed as a percentage of the
face value of the bond.
Debt securities, page 59 Financial instruments that represent loans to corporations. Longterm debt securities are called bonds and can be
bought and sold in the bond market.
Equity securities, page 59 Financial instru-
Concept Check | 2.3
1. What are debt and equity
securities, and how do they
differ?
2. How is a primary market different
from a secondary market?
3. How does common stock differ
from preferred stock?
ments that represent ownership claims on a business. Equity securities for corporations are called
shares of stock and can be bought and sold in the
stock market.
Primary market, page 57 A financial market
where new security issues are initially bought and
sold.
Proprietary trading, page 65 Trading in
which a bank uses its capital to make speculative
bets on derivatives and securities.
Secondary market, page 57 The financial
market where previously issued securities such as
stocks and bonds are bought and sold.
Face value or par value, page 59 On the
Security, page 57 A negotiable instrument
face of a bond, the stated amount that the firm is
to repay on the maturity date.
that represents a financial claim that has value.
Securities are broadly classified as debt securities
(bonds) and equity securities (shares of common
stock).
Maturity, page 59 The date when a debt must
be repaid.
Note, page 59 A term used to refer to indebtedness. Notes generally have a maturity of between 1 and 10 years when originally issued.
Study Questions
2–1. In Regardless of Your Major: Defined Benefit vs. Defined Contribution Retirement
Plans on page 52, two types of pension plans are discussed. Describe each. Which
type is now the dominant type in use?
2–2. What are the three principal sets of players that interact in the financial markets?
2–3. What is a financial intermediary? List and describe the principal types of financial
intermediaries in the U.S. financial markets.
2–4. What do investment banks do in the financial markets?
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CHAPTER 2 | Firms and the Financial Markets
69
2–5. Describe the difference between the primary market and the secondary market.
2–6. What is a mutual fund, and how does it differ from an exchange-traded fund (ETF)?
2–7. What is the difference between a debt security and an equity security?
2–8. What makes preferred stock “preferred”?
2–9. In Finance for Life: Controlling Costs in Mutual Funds on page 56, the importance
of keeping expenses down is discussed. The Financial Industry Regulatory Authority website provides an easy way to compare mutual funds. Go to the website, http://
apps.finra.org/fundanalyzer/1/fa.aspx, and enter “VFINX” (the ticker symbol for
Vanguard 500 Index Fund Investor Class, “ABFAX” (American Beacon Balanced
Fund Class A), and “AMREX” (American Growth Fund Series Two E). Now click
on “Show Results.” Set your investment at $10,000, your return at 8%, and your
period at 10 years. What is your profit or loss? Why do you think there are such big
differences? (Think expenses and fees.)
2–10. The distribution of financial assets around the world is described in Finance in a Flat
World: Where’s the Money Around the World on page 64. What country dominates in
terms of the stock market and total financial assets? Of the United Kingdom, Germany,
and France, which country has the most financial assets, and which country has the least?
2–11. Describe the costs and benefits of owning mutual funds.
2–12. Describe the tax benefits to a corporation of issuing debt rather than issuing stock.
2–13. Go to Yahoo Finance (http://finance.yahoo.com), and enter “GOOG” (the ticker
symbol for Alphabet, formerly Google) in the “Enter Symbol(s)” box at the top
of the page. What is the price at which the stock last traded? What is the last trade
time, and how long ago was that? What is the day’s price range for the stock?
What is the closing change in the price of the stock, in both dollar and percentage
terms? What is the stock’s 52-week price range? Now check out some of the links
on the left-hand side of the page. What kind of information listed there do you find
interesting?
2–14. Go to the Market Watch website (www.marketwatch.com), and click on “Sections”
then on “Personal Finance.” This is a great resource for information and help in managing your personal finances. Find an article you like, read it, and write a summary
of it. Consider bookmarking this website—it’s one you might want to start visiting
on a regular basis.
2–15. Go to the Motley Fool website (www.fool.com), and under the tab “Guides,” click
on “Retirement.” Describe the information available here for planning for your
retirement.
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Introduction to Financial Management
(Chapters 1, 2, 3, 4)
Part 4
Capital Structure and Dividend Policy
(Chapters 15, 16)
Part 2
Valuation of Financial Assets
(Chapters 5, 6, 7, 8, 9, 10)
Part 5
Liquidity Management and Special Topics in Finance
(Chapters 17, 18, 19, 20)
Part 3
Capital Budgeting (Chapters 11, 12, 13, 14)
C H A P T E R
3
Part 1
Understanding Financial
Statements
Chapter Outline
3.1
An Overview of the Firm’s
Financial Statements (pgs. 72–74)
3.2
The Income Statement
(pgs. 74–79)
3.3
Corporate Taxes
(pgs. 79–81)
3.4
The Balance Sheet
(pgs. 81–89)
3.5
The Cash Flow Statement
(pgs. 90–98)
Objective 1. Describe the content of the four basic
financial statements and discuss the importance of
financial statement analysis to the financial manager.
Objective 2. Evaluate firm profitability using the
income statement.
Objective 3. Estimate a firm’s tax liability using the
corporate tax schedule and distinguish between the
average and marginal tax rates.
Objective 4. Use the balance sheet to describe a
firm’s investments in assets and the way it has
financed them.
Objective 5. Identify the sources and uses of cash for
a firm using the firm’s cash flow statement.
70
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Principles
P
1, P 3, P 4, and P 5 Applied
In this chapter, we apply P Principle 1: Money Has a Time Value,
P Principle 3: Cash Flows Are the Source of Value, P Principle 4:
Market Prices Reflect Information, and P Principle 5: Individuals
Respond to Incentives. Financial statements are prepared in accordance with a set of accounting principles that separates reported
statement figures, present values, and cash flows, but we can
determine the cash flow implications for the firm from its reported
financial statements. It is critical that we learn how to do this. Moreover, we learn that the firm’s financial statements do contain information that can be important to the formation of investor
expectations concerning the firm’s future performance and, consequently, market prices.
In May 1904, Henry Royce and Charles Rolls formed
a partnership to manufacture a range of luxury cars
under the name Rolls-Royce. Today, it is one of the
most iconic premium brands in the world. During
the two World Wars, the company designed superior
­engines for airplanes in the United Kingdom and quickly
made a name for itself through its cutting-edge and
pioneering ­technology. Due to its strategic importance
for defense industries in the United Kingdom, the
company was ultimately divided into different segments
and part of it was nationalized in 1971. The Rolls Royce
Motors Cars division is now owned and operated by
the Volkswagen Group, while the BMW Group has acquired the license to use the Rolls-Royce brand
name and logo.
For a very long time, Rolls-Royce seemed invincible as its profits kept soaring and it was at the forefront of innovation. However, between 2014 and 2018, profits dwindled, and the company either recorded losses or made
less than £100m in profits. Predictably, its share prices fell from £9.03 in 2014 to £7.20 in 2019. Although it would
have been difficult to foresee Rolls-Royce’s performance perfectly, its financial statements contain information about
performance and financial health that is helpful in predicting future cash flows (remember P Principle 3: Cash Flows
Are the Source of Value), and this information is helpful in estimating the value of the firm’s common stock (remember
P Principle 4: Market Prices Reflect Information).
This is the first of two chapters that focus on accounting and, s­ pecifically, financial Statements. Because this isn’t
an accounting book, you might be asking yourself (or your teacher), “Why we are spending so much time delving into
financial statements?” The answer is simply that accounting is the language of business. A firm’s principal means
of communication with its stockholders and creditors is through its financial statements. Moreover, when managers
­communicate with their fellow employees about the firm’s performance, they often do so by using benchmarks based
on accounting profits.
In this chapter, we review the basic financial statements used by firms to report their financial performance.
These financial statements can be viewed as a model or representation of the firm at a particular point in time. We
first investigate why both a student of finance and a manager need to understand financial statements as well as the
basic accounting principles that underlie their construction.
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