Foundations of Finance: The Logic and Practice of Financial Management, 9th Edition PDF by Arthur J Keown, John D Martin and J William Petty


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

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

Foundations of Finance
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
Web Appendix A Using a Calculator
Available online at
Glossary 560
Indexes 569

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