## Foundations of Finance: The Logic and Practice of Financial Management, Ninth Edition

By Arthur J. Keown, John D. Martin and J. William Petty

**Content:**

Preface 16

Part 1 The Scope and Environment

of Financial Management 26

1 An Introduction to the Foundations of Financial

Management 26

The Goal of the Firm 27

Five Principles That Form the Foundations of Finance 28

Principle 1: Cash Flow Is What Matters 28

Principle 2: Money Has a Time Value 29

Principle 3: Risk Requires a Reward 29

Principle 4: Market Prices Are Generally Right 30

Principle 5: Conflicts of Interest Cause Agency Problems 32

The Global Financial Crisis 33

Avoiding Financial Crisis—Back to the Principles 34

The Essential Elements of Ethics and Trust 35

The Role of Finance in Business 36

Why Study Finance? 36

The Role of the Financial Manager 37

The Legal Forms of Business Organization 38

Sole Proprietorships 38

Partnerships 38

Corporations 39

Organizational Form and Taxes: The Double Taxation on Dividends 39

S-Corporations and Limited Liability Companies (LLCs) 40

Which Organizational Form Should Be Chosen? 40

Finance and the Multinational Firm: The New Role 41

Chapter Summaries 42 • Review Questions 44 • Mini Case 45

2 The Financial Markets and Interest Rates 46

Financing of Business: The Movement of Funds Through

the Economy 48

Public Offerings Versus Private Placements 49

Primary Markets Versus Secondary Markets 50

The Money Market Versus the Capital Market 51

Spot Markets Versus Futures Markets 51

Stock Exchanges: Organized Security Exchanges Versus Over-the-Counter

Markets, a Blurring Difference 51

Selling Securities to the Public 53

Functions 53

Distribution Methods 54

Private Debt Placements 55

Flotation Costs 57

Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley Act 57

Rates of Return in the Financial Markets 58

Rates of Return over Long Periods 58

Interest Rate Levels in Recent Periods 59

Interest Rate Determinants in a Nutshell 62

Estimating Specific Interest Rates Using Risk Premiums 62

Real Risk-Free Interest Rate and the Risk-Free Interest Rate 63

Real and Nominal Rates of Interest 63

Inflation and Real Rates of Return: The Financial Analyst’s Approach 65

The Term Structure of Interest Rates 67

Shifts in the Term Structures of Interest Rates 67

What Explains the Shape of the Term Structure? 69

Chapter Summaries 71 • Review Questions 74 • Study Problems 74 • Mini Case 77

3 Understanding Financial Statements and Cash Flows 78

The Income Statement 80

Coca-Cola’s Income Statement 82

Restating Coca-Cola’s Income Statement 83

The Balance Sheet 85

Types of Assets 85

Types of Financing 87

Coca-Cola’s Balance Sheet 89

Working Capital 90

Measuring Cash Flows 93

Profits Versus Cash Flows 93

The Beginning Point: Knowing When a Change in the Balance Sheet Is a Source

or Use of Cash 95

Statement of Cash Flows 95

Concluding Suggestions for Computing Cash Flows 102

What Have We Learned about Coca-Cola? 103

GAAP and IFRS 103

Income Taxes and Finance 104

Computing Taxable Income 104

Computing the Taxes Owed 105

The Limitations of Financial Statements and Accounting Malpractice 107

Chapter Summaries 109 • Review Questions 112 • Study Problems 113 • Mini Case 121

Appendix 3A: Free Cash Flows 124

Computing Free Cash Flows 124

Computing Financing Cash Flows 127

Study Problems 128

4 Evaluating a Firm’s Financial Performance 130

The Purpose of Financial Analysis 130

Measuring Key Financial Relationships 134

Question 1: How Liquid Is the Firm—Can It Pay Its Bills? 135

Question 2: Are the Firm’s Managers Generating Adequate Operating Profits

on the Company’s Assets? 140

Managing Operations 142

Managing Assets 143

Question 3: How Is the Firm Financing Its Assets? 147

Question 4: Are the Firm’s Managers Providing a Good Return on the Capital

Provided by the Company’s Shareholders? 150

Question 5: Are the Firm’s Managers Creating Shareholder Value? 155

The Limitations of Financial Ratio Analysis 162

Chapter Summaries 163 • Review Questions 166 • Study Problems 166

Mini Case 174

Part 2 The Valuation of Financial Assets 176

5 The Time Value of Money 176

Compound Interest, Future Value, and Present Value 178

Using Timelines to Visualize Cash Flows 178

Techniques for Moving Money Through Time 181

Two Additional Types of Time Value of Money Problems 186

Applying Compounding to Things Other Than Money 187

Present Value 188

Annuities 192

Compound Annuities 192

The Present Value of an Annuity 194

Annuities Due 196

**Amortized Loans** 197

Making Interest Rates Comparable 199

Calculating the Interest Rate and Converting It to an EAR 201

Finding Present and Future Values With Nonannual Periods 202

Amortized Loans With Monthly Compounding 205

The Present Value of an Uneven Stream and Perpetuities 206

Perpetuities 207

Chapter Summaries 208 • Review Questions 211 • Study Problems 211

Mini Case 219

6 The Meaning and Measurement of Risk and Return 220

Expected Return Defined and Measured 222

Risk Defined and Measured 225

Rates of Return: The Investor’s Experience 232

Risk and Diversification 233

Diversifying Away the Risk 234

Measuring Market Risk 235

Measuring a Portfolio’s Beta 242

Risk and Diversification Demonstrated 243

The Investor’s Required Rate of Return 246

The Required Rate of Return Concept 246

Measuring the Required Rate of Return 246

Chapter Summaries 249 • Review Questions 253 • Study Problems 253

Mini Case 258

7 The Valuation and Characteristics of Bonds 260

Types of Bonds 261

Debentures 261

Subordinated Debentures 262

Mortgage Bonds 262

Eurobonds 262

Convertible Bonds 262

Terminology and Characteristics of Bonds 263

Claims on Assets and Income 263

Par Value 263

Coupon Interest Rate 264

Maturity 264

Call Provision 264

Indenture 264

Bond Ratings 265

Defining Value 266

What Determines Value? 268

Valuation: The Basic Process 269

Valuing Bonds 270

Bond Yields 276

Yield to Maturity 276

Current Yield 278

Bond Valuation: Three Important Relationships 279

Chapter Summaries 284 • Review Questions 287 • Study Problems 288

Mini Case 291

8 The Valuation and Characteristics of Stock 292

Preferred Stock 293

The Characteristics of Preferred Stock 294

Valuing Preferred Stock 295

Common Stock 299

The Characteristics of Common Stock 299

Valuing Common Stock 301

The Expected Rate of Return of Stockholders 306

The Expected Rate of Return of Preferred Stockholders 307

The Expected Rate of Return of Common Stockholders 308

Chapter Summaries 311 • Review Questions 314 • Study Problems 314

Mini Case 317

9 The Cost of Capital 318

The Cost of Capital: Key Definitions and Concepts 319

Opportunity Costs, Required Rates of Return, and the Cost of Capital 319

The Firm’s Financial Policy and the Cost of Capital 320

Determining the Costs of the Individual Sources of Capital 321

The Cost of Debt 321

The Cost of Preferred Stock 323

The Cost of Common Equity 325

The Dividend Growth Model 326

Issues in Implementing the Dividend Growth Model 327

The Capital Asset Pricing Model 328

Issues in Implementing the CAPM 329

The Weighted Average Cost of Capital 331

Capital Structure Weights 332

Calculating the Weighted Average Cost of Capital 332

Calculating Divisional Costs of Capital 335

Estimating Divisional Costs of Capital 335

Using Pure Play Firms to Estimate Divisional WACCs 335

Using a Firm’s Cost of Capital to Evaluate New Capital Investments 337

Chapter Summaries 341 • Review Questions 343 • Study Problems 344

Mini Cases 348

Part 3 Investment in Long-Term Assets 350

10 Capital-Budgeting Techniques and Practice 350

Finding Profitable Projects 351

Capital-Budgeting Decision Criteria 352

The Payback Period 352

The Net Present Value 356

Using Spreadsheets to Calculate the Net Present Value 359

The Profitability Index (Benefit–Cost Ratio) 359

The Internal Rate of Return 362

Computing the IRR for Uneven Cash Flows with a Financial Calculator 364

Viewing the NPV–IRR Relationship: The Net Present Value Profile 365

Complications with the IRR: Multiple Rates of Return 367

The Modified Internal Rate of Return (MIRR) 368

Using Spreadsheets to Calculate the MIRR 371

A Last Word on the MIRR 371

Capital Rationing 372

The Rationale for Capital Rationing 373

Capital Rationing and Project Selection 373

Ranking Mutually Exclusive Projects 374

The Size-Disparity Problem 374

The Time-Disparity Problem 375

The Unequal-Lives Problem 376

Chapter Summaries 380 • Review Questions 383 • Study Problems 383

Mini Case 390

11 Cash Flows and Other Topics in Capital Budgeting 392

Guidelines for Capital Budgeting 393

Use Free Cash Flows Rather Than Accounting Profits 393

Think Incrementally 393

Beware of Cash Flows Diverted from Existing Products 394

Look for Incidental or Synergistic Effects 394

Work in Working-Capital Requirements 394

Consider Incremental Expenses 395

Remember That Sunk Costs Are Not Incremental Cash Flows 395

Account for Opportunity Costs 395

Decide If Overhead Costs Are Truly Incremental Cash Flows 395

Ignore Interest Payments and Financing Flows 396

Calculating a Project’s Free Cash Flows 396

What Goes into the Initial Outlay 396

What Goes into the Annual Free Cash Flows over the Project’s Life 397

What Goes into the Terminal Cash Flow 399

Calculating the Free Cash Flows 399

A Comprehensive Example: Calculating Free Cash Flows 403

Options in Capital Budgeting 406

The Option to Delay a Project 407

The Option to Expand a Project 407

The Option to Abandon a Project 408

Options in Capital Budgeting: The Bottom Line 408

Risk and the Investment Decision 409

What Measure of Risk Is Relevant in Capital Budgeting? 410

Measuring Risk for Capital-Budgeting Purposes with a Dose of Reality—Is

Systematic Risk All There Is? 411

Incorporating Risk into Capital Budgeting 411

Risk-Adjusted Discount Rates 411

Measuring a Project’s Systematic Risk 414

Using Accounting Data to Estimate a Project’s Beta 415

The Pure Play Method for Estimating Beta 415

Examining a Project’s Risk Through Simulation 415

Conducting a Sensitivity Analysis Through Simulation 417

Chapter Summaries 418 • Review Questions 420 • Study Problems 420

Mini Case 426

Appendix 11A: The Modified Accelerated Cost Recovery System 428

What Does All This Mean? 429

Study Problems 429

Part 4 Capital Structure and Dividend Policy 430

12 Determining the Financing Mix 430

Understanding the Difference Between Business and Financial Risk 432

Business Risk 433

Operating Risk 433

Break-Even Analysis 433

Essential Elements of the Break-Even Model 434

Finding the Break-Even Point 436

The Break-Even Point in Sales Dollars 437

Sources of Operating Leverage 438

Financial Leverage 440

Combining Operating and Financial Leverage 442

Capital Structure Theory 444

A Quick Look at Capital Structure Theory 446

The Importance of Capital Structure 446

Independence Position 446

The Moderate Position 448

Firm Value and Agency Costs 450

Agency Costs, Free Cash Flow, and Capital Structure 452

Managerial Implications 452

The Basic Tools of Capital Structure Management 453

EBIT-EPS Analysis 453

Comparative Leverage Ratios 456

Industry Norms 457

Net Debt and Balance-Sheet Leverage Ratios 457

A Glance at Actual Capital Structure Management 457

Chapter Summaries 460 • Review Questions 463 • Study Problems 463

Mini Cases 466

13 Dividend Policy and Internal Financing 468

Key Terms 469

Does Dividend Policy Matter to Stockholders? 470

Three Basic Views 470

Making Sense of Dividend Policy Theory 473

What Are We to Conclude? 475

The Dividend Decision in Practice 476

Legal Restrictions 476

Liquidity Constraints 476

Earnings Predictability 477

Maintaining Ownership Control 477

Alternative Dividend Policies 477

Dividend Payment Procedures 477

Stock Dividends and Stock Splits 478

Stock Repurchases 479

A Share Repurchase as a Dividend Decision 480

The Investor’s Choice 481

A Financing or an Investment Decision? 482

Practical Considerations—The Stock Repurchase Procedure 482

Chapter Summaries 483 • Review Questions 485 • Study Problems 486

• Mini Case 489

Part 5 Working-Capital Management and International

Business Finance 490

14 Short-Term Financial Planning 490

Financial Forecasting 491

The Sales Forecast 491

Forecasting Financial Variables 491

The Percent of Sales Method of Financial Forecasting 492

Analyzing the Effects of Profitability and Dividend Policy on DFN 493

Analyzing the Effects of Sales Growth on a Firm’s DFN 494

Limitations of the Percent of Sales Forecasting Method 497

Constructing and Using a Cash Budget 498

Budget Functions 498

The Cash Budget 499

Chapter Summaries 501 • Review Questions 502 • Study Problems 503

Mini Case 508

15 Working-Capital Management 510

Managing Current Assets and Liabilities 511

The Risk–Return Trade-Off 512

The Advantages of Current versus Long-term Liabilities: Return 512

The Disadvantages of Current versus Long-term Liabilities: Risk 512

Determining the Appropriate Level of Working Capital 513

The Hedging Principle 513

Permanent and Temporary Assets 514

Temporary, Permanent, and Spontaneous Sources of Financing 514

The Hedging Principle: A **Graphic Illustration** 515

The Cash Conversion Cycle 516

Estimating the Cost of Short-Term Credit Using the Approximate

Cost-of-Credit Formula 518

Sources of Short-Term Credit 520

Unsecured Sources: Accrued Wages and Taxes 521

Unsecured Sources: Trade Credit 522

Unsecured Sources: Bank Credit 523

Unsecured Sources: Commercial Paper 525

Secured Sources: Accounts-Receivable Loans 527

Secured Sources: Inventory Loans 529

Chapter Summaries 530 • Review Questions 533 • Study Problems 534

16 International Business Finance 538

The Globalization of Product and Financial Markets 539

Foreign Exchange Markets and Currency Exchange Rates 540

Foreign Exchange Rates 541

What a Change in the Exchange Rate Means for Business 541

Exchange Rates and Arbitrage 544

Asked and Bid Rates 544

Cross Rates 544

Types of Foreign Exchange Transactions 546

Exchange Rate Risk 548

Interest Rate Parity 550

Purchasing-Power Parity and the Law of One Price 551

The International Fisher Effect 552

Capital Budgeting for Direct Foreign Investment 552

Foreign Investment Risks 553

Chapter Summaries 554 • Review Questions 556 • Study Problems 557

Mini Case 558

Web 17 Cash, Receivables, and Inventory Management

Available online at www.myfinancelab.com

Web Appendix A Using a Calculator

Available online at www.myfinancelab.com

Glossary 560

Indexes 569