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

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

**Contents:**

Preface xvii

PART 1 The Scope and Environment of Financial Management 2

1 An Introduction to the Foundations of Financial Management 2

The Goal of the Firm 3

Five Principles That Form the Foundations of Finance 4

Principle 1: Cash Flow Is What Matters 4

Principle 2: Money Has a Time Value 5

Principle 3: Risk Requires a Reward 5

Principle 4: Market Prices Are Generally Right 6

Principle 5: Conflicts of Interest Cause Agency Problems 8

The Essential Elements of Ethics and Trust 9

The Role of Finance in Business 10

Why Study Finance? 11

The Role of the Financial Manager 11

The Legal Forms of Business Organization 12

Partnerships 13

Corporations 13

Organizational Form and Taxes: The Double Taxation on Dividends

and Pass-Through Entities 14

S-Corporations and Limited Liability Companies (LLCs) 14

Which Organizational Form Should Be Chosen? 15

Finance and the Multinational Firm: The New Role 15

Developing Skills for Your Career 16

Chapter Summaries 17 • Review Questions 20 • Mini Case 21

2 The Financial Markets and Interest Rates 22

Financing of Business: The Movement of Funds Through the Economy 24

Public Offerings Versus Private Placements 25

Primary Markets Versus Secondary Markets 26

The Money Market Versus the Capital Market 27

Spot Markets Versus Futures Markets 27

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

a Blurring Difference 27

Selling Securities to the Public 29

Functions 29

Distribution Methods 30

Private Debt Placements 31

Flotation Costs 33

Regulation Aimed at Making the Goal of the Firm Work: The Sarbanes-Oxley Act 33

Rates of Return in the Financial Markets 34

Rates of Return over Long Periods 34

Interest Rate Levels in Recent Periods 35

Interest Rate Determinants in a Nutshell 38

Estimating Specific Interest Rates Using Risk Premiums 38

Real Risk-Free Interest Rate and the Risk-Free Interest Rate 39

Real and Nominal Rates of Interest 39

Inflation and Real Rates of Return: The Financial Analyst’s Approach 41

The Term Structure of Interest Rates 43

Shifts in the Term Structures of Interest Rates 43

What Explains the Shape of the Term Structure? 45

Chapter Summaries 47 • Review Questions 50 • Study Problems 50, Mini Case 53

3 Understanding Financial Statements and Cash Flows 54

The Income Statement 56

The Makeup of an Income Statement 56

Walmart’s Income Statement 57

Restating Walmart’s Income Statement 59

The Balance Sheet 61

Types of Assets 62

Types of Financing 63

Walmart’s Balance Sheet 65

Working Capital 66

Measuring Cash Flows 69

Profits Versus Cash Flows 69

The Beginning Point: Changes in the Balance Sheet and Cash Flows 70

Statement of Cash Flows 71

Concluding Suggestions for Computing Cash Flows 78

What Have We Learned about Walmart? 79

The Limitations of Financial Statements and Accounting Malpractice 80

Chapter Summaries 80 • Review Questions 83 • Study Problems 84, Mini Case 91

Appendix 3A: Free Cash Flows 94

Computing Free Cash Flows 94

Computing Financing Cash Flows 96

Study Problems 97

4 Evaluating a Firm’s Financial Performance 100

The Purpose of Financial Analysis 100

Measuring Key Financial Relationships 103

Question 1: How Liquid Is the Firm—Can It Pay Its Bills? 105

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

on the Company’s Assets? 110

Managing Operations 112

Managing Assets 112

Question 3: How Is the Firm Financing Its Assets? 117

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

Provided by the Company’s

Shareholders? 120

Question 5: Are the Firm’s Managers Creating Shareholder Value? 124

The Limitations of Financial Ratio Analysis 129

Chapter Summaries 130 • Review Questions 133 • Study Problems 133, Mini Case 140

PART 2 The Valuation of Financial Assets 142

5 The Time Value of Money 142

Compound Interest, Future Value, and Present Value 144

Using Timelines to Visualize Cash Flows 144

Techniques for Moving Money Through Time 147

Two Additional Types of Time Value of Money Problems 152

Applying Compounding to Things Other Than Money 153

Present Value 154

Annuities 158

Compound Annuities 158

The Present Value of an Annuity 160

Annuities Due 162

Amortized Loans 163

Making Interest Rates Comparable 165

Calculating the Interest Rate and Converting It to an EAR 167

Finding Present and Future Values With Nonannual Periods 168

Amortized Loans With Monthly Compounding 171

The Present Value of an Uneven Stream and Perpetuities 172

Perpetuities 173

Chapter Summaries 174 • Review Questions 177 • Study Problems 177, Mini Case 185

6 The Meaning and Measurement of Risk and Return 186

Expected Return Defined and Measured 188

Risk Defined and Measured 191

Rates of Return: The Investor’s Experience 198

Risk and Diversification 199

Diversifying Away the Risk 200

Measuring Market Risk 201

Measuring a Portfolio’s Beta 208

Risk and Diversification Demonstrated 209

The Investor’s Required Rate of Return 212

The Required Rate of Return Concept 212

Measuring the Required Rate of Return 212

Chapter Summaries 215 • Review Questions 219 • Study Problems 219, Mini Case 224

7 The Valuation and Characteristics of Bonds 226

Types of Bonds 227

Debentures 227

Subordinated Debentures 228

Mortgage Bonds 228

Eurobonds 228

Convertible Bonds 228

Terminology and Characteristics of Bonds 229

Claims on Assets and Income 230

Par Value 230

Coupon Interest Rate 230

Maturity 230

Call Provision 230

Indenture 231

Bond Ratings 231

Defining Value 232

What Determines Value? 234

Valuation: The Basic Process 235

Valuing Bonds 236

Bond Yields 242

Yield to Maturity 242

Current Yield 244

Bond Valuation: Three Important Relationships 245

Chapter Summaries 250 • Review Questions 253 • Study Problems 254, Mini Case 257

8 The Valuation and Characteristics of Stock 258

Preferred Stock 260

The Characteristics of Preferred Stock 260

Valuing Preferred Stock 261

Common Stock 265

The Characteristics of Common Stock 265

Valuing Common Stock 267

The Expected Rate of Return of Stockholders 272

The Expected Rate of Return of Preferred Stockholders 273

The Expected Rate of Return of Common Stockholders 274

Chapter Summaries 277 • Review Questions 280 • Study Problems 280, Mini Case 283

9 The Cost of Capital 284

The Cost of Capital: Key Definitions and Concepts 285

Capital Structure 285

Opportunity Costs, Required Rates of Return, and the Cost of Capital 286

The Firm’s Financial Policy and the Cost of Capital 287

Determining the Costs of the Individual Sources of Capital 288

The Cost of Debt 288

The Cost of Preferred Stock 291

The Cost of Common Equity 292

The Dividend Growth Model and the Implied Cost of Equity 293

Issues in Implementing the Dividend Growth Model 294

The Capital Asset Pricing Model 295

Issues in Implementing the CAPM 296

The Weighted Average Cost of Capital 298

Capital Structure Weights 298

Calculating the Weighted Average Cost of Capital 299

Calculating Divisional Costs of Capital 301

Estimating Divisional Costs of Capital 301

Using Pure Play Firms to Estimate Divisional WACCs 301

Using a Firm’s Cost of Capital to Evaluate New Capital Investments 305

Chapter Summaries 307 • Review Questions 310 • Study Problems 310, Mini Cases 316

PART 3 Investment in Long-Term Assets 318

10 Capital-Budgeting Techniques and Practice 318

Finding Profitable Projects 319

Capital-Budgeting Decision Criteria 320

The Payback Period 320

The Net Present Value 324

Using Spreadsheets to Calculate the Net Present Value 327

The Profitability Index (Benefit–Cost Ratio) 327

The Internal Rate of Return 330

Computing the IRR for Uneven Cash Flows with a Financial Calculator 332

Viewing the NPV–IRR Relationship: The Net Present Value Profile 333

Complications with the IRR : Multiple Rates of Return 334

The Modified Internal Rate of Return (MIRR)2 335

Using Spreadsheets to Calculate the MIRR 338

A Last Word on the MIRR 339

Capital Rationing 339

The Rationale for Capital Rationing 340

Capital Rationing and Project Selection 341

Ranking Mutually Exclusive Projects 341

The Size-Disparity Problem 342

The Unequal-Lives Problem 343

Chapter Summaries 346 • Review Questions 349 • Study Problems 350, Mini Case 356

11 Cash Flows and Other Topics in Capital Budgeting 358

Guidelines for Capital Budgeting 359

Use Free Cash Flows Rather Than Accounting Profits 359

Think Incrementally 359

Beware of Cash Flows Diverted from Existing Products 360

Look for Incidental or Synergistic Effects 360

Work in Working-Capital Requirements 360

Consider Incremental Expenses 361

Remember That Sunk Costs Are Not Incremental Cash Flows 361

Account for Opportunity Costs 361

Decide If Overhead Costs Are Truly Incremental Cash Flows 361

Ignore Interest Payments and Financing Flows 362

Calculating a Project’s Free Cash Flows 362

What Goes into the Initial Outlay 362

What Goes into the Annual Free Cash Flows over the Project’s Life 363

What Goes into the Terminal Cash Flow 365

Calculating the Free Cash Flows 366

A Comprehensive Example: Calculating Free Cash Flows 370

Options in Capital Budgeting 374

The Option to Delay a Project 374

The Option to Expand a Project 375

The Option to Abandon a Project 376

Options in Capital Budgeting: The Bottom Line 376

Risk and the Investment Decision 376

What Measure of Risk Is Relevant in Capital Budgeting? 377

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

Is Systematic Risk All There Is? 378

Incorporating Risk into Capital Budgeting 379

Risk-Adjusted Discount Rates 379

Measuring a Project’s Systematic Risk 382

Using Accounting Data to Estimate a Project’s Beta 382

The Pure Play Method for Estimating Beta 383

Examining a Project’s Risk Through Simulation 383

Conducting a Sensitivity Analysis Through Simulation 385

Chapter Summaries 386 • Review Questions 388 • Study Problems 388, Mini Case 394

Appendix 11A: The Modified Accelerated Cost Recovery System 396

What Does All This Mean? 397

Study Problems 397

PART 4 Capital Structure and Dividend Policy 398

12 Determining the Financing Mix 398

Understanding the Difference Between Business and Financial Risk 400

Business Risk 401

Operating Risk 401

Break-Even Analysis 401

Essential Elements of the Break-Even Model 402

Finding the Break-Even Point 404

The Break-Even Point in Sales Dollars 405

Sources of Operating Leverage 406

Financial Leverage 408

Combining Operating and Financial Leverage 410

Capital Structure Theory 412

A Quick Look at Capital Structure Theory 414

The Importance of Capital Structure 414

Independence Position 414

The Moderate Position 416

Firm Value and Agency Costs 418

Agency Costs, Free Cash Flow, and Capital Structure 420

Managerial Implications 420

The Basic Tools of Capital Structure Management 421

EBIT-EPS Analysis 421

Comparative Leverage Ratios 424

**Industry Norms** 425

Net Debt and Balance-Sheet Leverage Ratios 425

A Glance at Actual Capital Structure Management 425

Chapter Summaries 428 • Review Questions 431 • Study Problems 432, Mini Cases 434

13 Dividend Policy and Internal Financing 438

How do Firms Distribute Firm Profits to their Stockholders? 439

Does Dividend Policy Matter to Stockholders? 440

Three Basic Views 440

Making Sense of Dividend Policy Theory 442

What Are We to Conclude? 445

The Dividend Decision in Practice 446

Legal Restrictions 446

Liquidity Constraints 446

Earnings Predictability 446

Maintaining Ownership Control 447

Alternative Dividend Policies 447

Dividend Payment Procedures 447

Stock Dividends and Stock Splits 448

Stock Repurchases 449

A Share Repurchase as a Dividend Decision 450

The Investor’s Choice 451

A Financing Decision or an Investment Decision? 452

Practical Considerations—The Stock Repurchase Procedure 452

Chapter Summaries 453 • Review Questions 455 • Study Problems 456, Mini Case 459

PART 5 Working-Capital Management and International Business Finance 460

14 Short-Term Financial Planning 460

Financial Forecasting 461

The Sales Forecast 461

Forecasting Financial Variables 461

The Percent of Sales Method of Financial Forecasting 462

Analyzing the Effects of Profitability and Dividend Policy on DFN 463

Analyzing the Effects of Sales Growth on a Firm’s DFN 464

Limitations of the Percent of Sales Forecasting Method 467

Constructing and Using a Cash Budget 468

Budget Functions 468

The Cash Budget 469

Chapter Summaries 471 • Review Questions 473 • Study Problems 473

15 Working-Capital Management 480

Managing Current Assets and Liabilities 481

The Risk–Return Trade-Off 482

The Advantages of Current versus Long-term Liabilities: Return 482

The Disadvantages of Current versus Long-term Liabilities: Risk 482

Determining the Appropriate Level of Working Capital 483

The Hedging Principle 483

Permanent and Temporary Assets 484

Temporary, Permanent, and Spontaneous Sources of Financing 484

The Hedging Principle: A Graphic Illustration 484

Using the Cash Conversion Cycle 486

Estimating the Cost of Short-Term Credit Using the Approximate Cost-of-Credit Formula 488

Evaluating Sources of Short-Term Credit 490

Unsecured Sources: Accrued Wages and Taxes 490

Unsecured Sources: Trade Credit 492

Unsecured Sources: Bank Credit 493

Finance at Work 495

Unsecured Sources: Commercial Paper 496

Secured Sources: Accounts-Receivable Loans 498

Secured Sources: Inventory Loans 500

Chapter Summaries 501 • Review Questions 504 • Study Problems 505

16 International Business Finance 510

The Globalization of Product and Financial Markets 511

Foreign Exchange Markets and Currency Exchange Rates 512

Foreign Exchange Rates 513

What a Change in the Exchange Rate Means for Business 513

Exchange Rates and Arbitrage 516

Asked and Bid Rates 516

Cross Rates 517

Types of Foreign Exchange Transactions 518

Exchange Rate Risk 520

Interest Rate Parity 522

Purchasing-Power Parity and the Law of One Price 523

The International Fisher Effect 524

Capital Budgeting for Direct Foreign Investment 524

Repatriation of Profits and Taxation of Profits Abroad 525

Foreign Investment Risks 525

Chapter Summaries 526 • Review Questions 529 • Study Problems 529, Mini Case 530

Web 17 Cash, Receivables, and Inventory Management

Available online at www.pearson.com/mylab/finance

Web Appendix A Using a Calculator

Available online at www.pearson.com/mylab/finance

Glossary 532

Indexes 541