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Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. IMlliam Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

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EBITDAE01®

FCFt

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IRR

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NPV

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PI

PMT

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effective annual rate

earnings before interest and taxes

earnings before interest, taxes, depreciation, and amortization

Economic Value Added

the annual free cash flow in time period t

the future value of $1 at the end of year i

the initial outlay

internal rate of return

weighted average cost of capital

cost of common equity

cost of new common equity

cost of debt financing

the modified internal rate of return

the number of years until payment will be received or duringwhich compounding occurs

net present value

operating return on assets

current selling price of a security

profitability index

the annuity payment deposited or received each period overthe life of the annuity.

the present value of a future sum of money

required rate of return of an investor.

risk free rate of interest.

expected rate of return on the market portfolio of all risky investments.

return on assets

standard deviation

Foundations of Finance; The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

Foundations of FinanceThe Logic and Practice of Financial Management

Seventh Edition


The Prentice Hall Series in FinanceAIexand er/S harpelB aileyFundrnnentals of Investments

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DietrichFinancilll Services and Finaneillllnstitutions:Value Creation in Tbe01] IInd P.ractiee

DormanIntroduction to Risk iHIl1Ulgement and Insnnmce

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GuthrielLemonlVlatbematits of Interest Rlltes and Finance

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Foundations of FinanceThe Logic and Practice of Financial Management

Seventh Edition

Arthur J. I(eownVirginia Polytechnic Institute and State University

R.B. Pamplin Professor of Finance

John D. MartinBaylor University

Professor of FinanceCarr P.Collins Chair in Finance

J. William PettyBaylor University

Professor of FinanceW. W. Caruth Chair in Entrepreneurship

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Keown, Arth "r .J .Foundations of finance: the logic and practice of fin,lllcial management I Arthur].

Keown, John D. Martin,]. vVilliam Petty.-7th cd.p. cm.

Includes bibliographical references and index.ISBN-13: 978-0-13-611365-2ISBN-IO: 0-13-611365-6

I. Corporations-Finance. I.i\1artin, John D. II. Petty,]. vVilliam. III. TitleHG4026.F672011

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PEARSON------- www.pearsonhighered.cotnISBN-13: 978-0-13-611365-2

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Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. IIV1l1iamPetty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

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To my parents, from whom I learned the most.Arthur J. Keown

To the Martin women-wife Sally and daughter-in-law Mel,the Martin men-sons Dave andJess, andMartin boys-grandsons Luke and Burke.

John D. Martin

To my grandchildren, Mackenzie Kate, Ashley Kate,Cameron Petty, John Carter, and Erin Marie, who bless

me every day and make my life so much fun.J. William Petty

Foundations of Finance; The Logic and Practice of Financial Management, Seventh Edition, by Arthur J Keown, John D. Martin, and J. William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D Martin, and J. IMlliam Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

About the AuthorsArthur J. Keown is the R. B. Pamplin Professor of Finance at Virginia PolytechnicInstitute and State University. He received his bachelor's degree from Ohio WesleyanUniversity, his M.B.A. from the University of Michigan, and his doctorate from IndianaUniversity. An award-winning teacher, he is a member of the Academy of 'leachingExcellence; has received five Certificates of Teaching Excellence at Virginia 'Iech, the\tv. E. Wine Award for 'leaching Excellence, and the Alumni 'leaching Excellence Award;and in 1999 received the Outstanding Faculty Award from the State of Virginia.Professor Keown is widely published in academic journals. His work has appeared inThe Journal (!f Finance, the Joun1fl1 of Financial Economics, the Journal of Fin (tncial andQuantitative Ana~y.ri.r, The Journal of Financial Re.rearcb, the Journal of Banking and Finance,Financial N!anagement, the Journal of Portfolio A1anagement, and many others. In additionto Foundation.r of Finance , two other of his books are widely used in college finance classesall over the country-Basic Financial lV!anagement and Personal Finance: Turning lV1one.yinto r¥ealth. Professor Keown is a Fellow of the Decision Sciences Institute, a member ofthe Board of Directors of the Financial Management Association, and former head of thefinance department at Virginia Tech. In addition, he recently served as the co-editor ofThe J01l1'nal of Financial Re.rearcb for six and a half years and as the co-editor of theFinancial Management Association's Survey and Syntbe.ri.r series for six years. TIe liveswith his wife and two children in Blacksburg, Virginia, where he collects original art from}VIad Magazine.

John D. Martin is Professor of Finance and the holder of the Carr P. Collins Chairof Finance at Baylor University. Dr. Martin came to Baylor University in 1998 from theUniversity of Texas at Austin where he taught for nineteen years and was the 1\1argaretand Eugene 1\1cDennott Centennial Professor of Finance. He teaches corporate financeand his research interests are in corporate governance, the evaluation of firm perfor-mance, and the design of incentive compensation plans. Dr. Martin has published widelyin academic journals including the Journal of Financial Economics, The Journal ofFinrmce,Journal of i110netary EconomirI, Journal of Financial and Quantitative Analysi.r, Journal ofCorporate Finance, Financial iWanagement, and iWanagement Science. His work has alsoappeared in a number of professional publications including Directors and Boards, theFinancial Analy.rts' .Journal, the .Journal of Portfolio lV!anagement, and the .Journal of AppliedCorporate Finance. In addition to this book Dr. Martin is co-author of nine books includ-ing Financial il1anagement (9th ed., Prentice Hall), The Tbeory of Finance (Dryden Press),Financial Analysis (2nd ed., McGraw Hill), and Value Based Management (HarvardBusiness School Press), and he is currently writing a book on interest rate modeling. Heserves on the editorial boards of eight journals and has delivered executive education pro-grams for a number of firms including Shell Chemical, Shell E&P, 1exas Instruments,and The Associates.

J. William Petty, Ph0, University onexas at Austin, is Professor of Finance andW. \tv. Caruth Chair of Entrepreneurship. Dr. Petty teaches entrepreneurial finance,both at the undergraduate and graduate levels. He is a University Master 'Teacher. Tn2008, the Acton Foundation for Entrepreneurship Excellence selected him as theNational Entrepreneurship 'Teacher ofthe Year. His research interests include the financ-ing of entrepreneurial firms and shareholder value-based management. He has served asthe co-editor for the .Journal of Financial Re.rearcb and the editor of the Journal ofE'lt1'epreneurial Finance. He has published articles in various academic and professional

vii

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition. by Arthur J. Keown, John D. Martin, and J. William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.


ContentsPreface xxm

IZ!D The Scope and Environment of FinancialManagement 2

An Introduction to the Foundations of FinancialManagement 2The Goal of the Firm 3

Five Principles that Form the Foundations of Finance 4

Principle 1: Cash Flow Is What Matters 4Principle 2: Money Has a Time Value 4Principle 3: Risk Requires a Reward 5Principle 4: Market Prices Are Generally Right 6Principle 5: Conflicts of Interest Cause Agency Problems 7Avoiding Financial Crisis-Back to the Principles 8The Essential Elements of Ethics and Trust 9

Ethics in Financial Management The Wall Street Journal Workplace-EthicsQuiz 10

The Role of Finance in Business 10

Why Study Finance? 11The Role ofthe Financial Manager 11

The Legal Forms of Business Organization 12

Sole Proprietorships 12Partnerships 13Corporations 13Organizational Form and Taxes:The Double Taxation on Dividends 145-Corporations and Limited Liability Companies (LLC) 14Which Organizational Form Should Be Chosen? 14

Finance and the Multinational Firm: The New Role 15

Summary 15' Key Terms .J 6 • Review Questions 16' Mini Case 17

2 The Financial Markets and Interest Rates 18Financing of Business:The Movement of Funds through the Economy 19

Public Offerings Versus Private Placements 21Primary Markets Versus Secondary Markets 22The Money Market Versus the Capital Market 22Spot Markets Versus Futures Markets 23Organized Security Exchanges Versus Over-the-Counter Markets 23

The Investment-Banking Function 25

Functions 2SThe Demise of the Stand-Alone Investment-Banking Industry 26Distribution Methods 27

Private Debt Placements 29

Flotation Costs 30

Cautionary Tale Forgetting Principle 5: Conflicts of Interest Cause AgencyProblems 30

Regulation Aimed at Making the Goal of the Firm Work:The Sarbanes-Oxley Act 31

Rates of Return in the Financial Markets 31

Rates of Return over Long Periods 31Interest Rate Levels in Recent Periods 32


xi

About the Authors

journals including Journal of Financial and Quantitative Analysis, Financial lV!anagement,Journal of Portfolio lV!anagement, Journal of Applied Corporate Finance, and AccountingReview. Dr. Petty is co-author of a leading textbook in small business and entrepreneur-ship, Small BusinessA1anagement: Launching and Growing Ent7-epreneurial Ventures. He alsoco-authored Value-Based iVlanagement: Corporate America's Response to the ShareholderRevolmion, 2010. Finally, he serves on the Board of Directors of a publicly-traded oil andgas firm.


Brief ContentsIIZ!i1D The Scope and Environment of

Financial Management 2

1 An Introduction to the Foundations of Financial Management 22 The Financial Markets and Interest Rates 183 Understanding Financial Statements and Cash Flows 464 Evaluating a Firm's Financial Performance 84

&D The Valuation of Financial Assets 118

5 The Time Value of Money 1186 The Meaning and Measurement of Risk and Return 1567 The Valuation and Characteristics of Bonds 1888 The Valuation and Characteristics of Stock 2129 The Cost of Capital 234

Ii'!iJII Investment in Long-Term Assets 264

10 Capital-Budgeting Techniques and Practice 26411 Cash Flows and Other Topics in Capital Budgeting 302

Capital Structure and Dividend Policy 336

12 Determining the Financing Mix 33613 Dividend Policy and Internal Financing 372

Working-Capital Management andInternational Business Finance 392

14 Short-Term Financial Planning 39215 Working-Capital Management 41216 Current Asset Management 43617 International Business Finance 466

Appendix A: Using a Calculator 491

Glossary 503

Indexes 512


ix

Capital Rationing 282

The Rationale for Capital Rationing 282Capital Rationing and Project Selection 283

Ranking Mutually Exclusive Projects 284

The Size-Disparity Problem 284The Time-Disparity Problem 28SThe Unequal-Lives Problem 286

Ethics in Financial Management The Financial Downside of Poor EthicalBehavior 289

Ethics in Capital Budgeting 289

A Glance at Actual Capital-Budgeting Practices 289

Finance and the Multinational Firm: Capital Budgeting 290

Summary 291.· Key Terms 293· Re"iew Questions 29.3· Self-Test Problems 294• Stlldlj Problems 294· Mini Case 299· SeiFTeslSolnliol1 .301

11 Cash Flows and Other Topics in Capital Budgeting 302Guidelines for Capital Budgeting 302

Use Free Cash Flows Rather than Accounting Profits 303Think Incrementally 303Beware of Cash Flows Diverted from Existing Products 304Look for Incidental or Synergistic Effects 304Work in Working-Capital Requirements 304Consider Incremental Expenses 305RememberThat Sunk Costs Are Not Incremental Cash Flows 305Account for Opportunity Costs 305Decide If Overhead Costs Are Truly Incremental Cash Flows 305Ignore Interest Payments and Financing Flows 305

Finance at Work Universal Studios 306

An Overview of the Calculations of a Project's Free Cash Flows 306

What Goes Into the Initial Outlay 306What Goes Into the Annual Free Cash Flows over the Project's Life 307What Goes Into the Terminal Cash Flow 308Calculating the Free Cash Flows 309A Comprehensive Example: Calculating Free Cash Flows 312

Can You Do It? Calculating Operating Cash Flows 312

Did You Get It? Calculating Operating Cash Flows 313

Can You Do It? Calculating Free Cash Flows 315

Options in Capital Budgeting 315

Did You Get It? Calculating Free Cash Flows 316

The Option to Delay a Project 316The Option to Expand a Project 317The Option to Abandon a Project 317Options in Capital Budgeting:The Bottom Line 317

Risk and the Investment Decision 318

What Measure of Risk Is Relevant in Capital Budgeting? 318Measuring Risk for Capital-Budgeting Purposes with a Dose of Reality-Is Systematic Risk

All There Is? 320

Incorporating Risk Into Capital Budgeting 320

Risk-Adjusted Discount Rates 321Measuring a Project's Systematic Risk 322Using Accounting Data to Estimate a Project's Beta 323The Pure Play Method for Estimating Beta 323

Examining a Project's Risk through Simulation 324

Simulation: Explained and Illustrated 324Conducting a Sensitivity Analysis through Simulation 325

Foundations of Finance: The Logic and Practice of Financial Managemenl, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

Contents

Contents

Can You Do It? Calculating the Cost of Debt Financing 240

Can You Do It? Calculating the Cost of Preferred Stock Financing 240

Did You Get It? Calculating the Cost of Debt Financing 241

Did You Get It? Calculating the Cost of Preferred Stock Financing 241

Issues in Implementing the Dividend Growth Model 241The Capital Asset Pricing Model 242Issues in Implementing the CAPM 242

Can You Do It? Calculating the Cost of New Common Stock Using the DividendGrowth Model 243

Can You Do It? Calculating the Cost of Common Stock Using the CAPM 243

Finance at Work IPOs: Should a Firm Go Public? 244

The Weighted Average Cost of Capital 245

Did You Get It? Calculating the Cost of New Common Stock Using the DividendGrowth Model 245

Did You Get It? Calculating the Cost of Common Stock Using the CAPM 245

Capital Structure Weights 246Calculating the Weighted Average Cost of Capital 246

Cautionary Tale Forgetting Principle 3: Risk Requires a Reward 248

Calculating Divisional Costs of Capital: PepsiCo Inc. 248

Can You Do It? Calculating the Weighted Average Cost of Capital 248

Finance at Work The Pillsbury Company Adopts EVA with a Grassroots EducationProgram 249

Did You Get It? Calculating the Weighted Average Cost of Capital 250

Using a Firm's Cost of Capital to Evaluate New Capital Investments 251

Finance at Work Weighted Average Costs of Capital Estimates: 1993-2005 252

Finance and the Multinational Firm:Why Do Interest Rates Differ BetweenCountries? 253

Can You Do It? Evaluating Interest Rate Parity Across Countries 253

Did You Get It? Evaluating Interest Rate Parity Across Countries 254

Summary 255' Key Terms 256' Review Questions 257' Self-Test Problems 257• Study Problems 258' MiJli Case 260' Self-Test Solutions 261

mIll Investment in Long-Term Assets 264

10 Capital-Budgeting Techniques and Practice 264Finding Profitable Projects 265

Cautionary Tale Forgetting Principle 3: Risk Requires a Reward and Principle 4:Market Prices Are Generally Right 266

Capital-Budgeting Decision Criteria 267

The Payback Period 267The Net Present Value 268Using Spreadsheets to Calculate the Net Present Value 271

Can You Do It? Determining the NPVof a Project 271

The Profitability Index (Benefit-Cost Ratio) 272

Did You Get It? Determining the NPV of a Project 273

The Internal Rate of Return 274

Can You Do It? Determining the IRR of a Project 276

Viewing the NPV-IRR Relationship:The Net Present Value Profile 277

Did You Get It? Determining The lRR of a Project 277

Complications with the IRR: Multiple Rates of Return 278The Modified Internal Rate of Return (MlRR)3 279Using Spreadsheets to Calculate the MIRR 281


Contents

Interest Rate Determinants in a Nutshell 35

Estimating Specific Interest RatesUsing RiskPremiums: An Example 35Realand Nominal Ratesof Interest 35

Can You Do It? 35

Did You Get It? 36Inflation and RealRatesof Return:The Financial Analyst's Approach 37

Can You Do It? Solving for the Real Rate of Interest 37

Did You Get It? Solving for the Real Rate of Interest 38

TheTerm Structure of Interest Rates 39Observing the Historical Term Structures of Interest Rates 39

Can You Do It? Solving for the Nominal Rate of Interest 39

Did You Get It? Solving for the Nominal Rate of Interest 40

What Explains the Shape of the Term Structure? 40

Finance and the Multinational Firm: Efficient Financial Markets andIntercountry Risk 42

Summary 43· Key Terms 44· Revieu' Questions 44' Study Problems 45• Mini Case 45

3 Understanding Financial Statementsand Cash Flows 46The Income Statement 47

Finance at Work The Lessons of Adversity 49

Can You Do It? Preparing an Income Statement 51

Did You Get It? Preparing an Income Statement 53

The Balance Sheet 53

Types of Assets 54

Finance at Work Goldman Sachs Announces First Quarter 2009Earnings 56

Types of Financing 56Working Capital 58Debt Ratio 59

Can You Do It? Preparing a Balance Sheet 59

Did You Get It? Preparing a Balance Sheet 60

Measuring Cash Flows 61

Can You Do It? How Much Can You Trust a Brother-In-Law? 66

Did You Get It? How Much Can You Trust a Brother-In-Law? 68

Can You Do It? Measuring Cash Flows 68

Did You Get It? Measuring Cash Flows 69

Income Taxes and Finance 69

Computing Taxable Income 69Computing the TaxesOwed 70

Can You Do It? Computing a Corporation's Income Taxes 71

Did You Get It? Computing a Corporation's Income Taxes 71

Summary 72' Key Tenus 72· RC'(Jiew Questions 73' Selj~ Test Problems 73• Study Problems 74' Mini Case 79' Self-Test Solution 82

4 Evaluating a Firm's Financial Performance 84The Purpose of Financial Analysis 86

Measuring Key Financial Relationships 88

Question 1:How Liquid Isthe Firm-Can It PayIts Bills? 89


Foundations of Finance: The Logic and Practice of Financial Management, SeventhEdition,by Arthur J. Keown,John D. Martin,and J. William Petty.Publishedby PrenticeHall. Copyright© 2011 by Pearson Education,Inc.

Can You Do It? Evaluating Disney's Liquidity 92

Question 2: Are the Firm's Managers Generating Adequate Operating Profits on theCompany's Assets? 92

Did You Get It? Evaluating Disney's Liquidity 93

Finance at Work Managing by the Numbers 95

Can You Do It? Evaluating Disney's Operating Return on Assets 96

Ethics in Financial Management Fraud's Red Flags 97

Question 3: How Is the Firm Financing Its Assets? 97

Did You Get It? Evaluating Disney's Operating Return on Assets 98

Can You Do It? Evaluating Disney's Financing Decisions 99

Question 4: Are the Firm's Managers Providing a Good Return on the Capital Providedby the Company's Shareholders? 99

Did You Get It? Evaluating Disney's Financing Decisions 100

Can You Do It? Evaluating Disney's Return on Equity 102

Did You Get It? Evaluating Disney's Return on Equity 103

Question 5:Are the Firm's Managers Creating Shareholder Value? 103

Can You Do It? Computing Disney's Price/Earnings Ratio and Price/BookRatio 104

Did You Get It? Computing Disney's Price/Earnings Ratio and Price/BookRatio 105

Can You Do It? Calculating Disney's Economic Value Added 107

The Limitations of Financial Ratio Analysis 107

Did You Get it? Calculating Disney's Economic Value Added 108

Summa!"y 108· Key Terms 109· Reviel.l' Questions 109 • SelF Test Problems 110• Study Problems 111· iVliuiCase :L16· SelFTest Solutions lJ6

miD The Valuation of Financial Assets 118

5 The Time Value of Money 118Compound Interest and Future Value 119

Using Timelines to Visualize Cash Flows 119Techniques for Moving Money Through Time 123Two Additional Types ofTime Value of Money Problems 127Applying Compounding to Things Other Than Money 128

Present Value 129

Cautionary Tale Forgetting Principle 4: Market Prices Are GenerallyRight 131

Can You Do It? Solving for the Present Value with Two Flows in DifferentYears 131

Annuities 132

Compound Annuities 132

Did You Get It? Solving for the Present Value with Two Flows in DifferentYears 133

The Present Value of an Annuity 134Annuities Due 136Amortized Loans 138

Making Interest Rates Comparable 140

Finding Present and Future Values with Nonannual Periods 141

Can You Do It? How Much Can You Afford to Spend on a House? An AmortizedLoan with Monthly Payments 142

Did You Get It? How Much Can You Afford to Spend on a House? An AmortizedLoan with Monthly Payments 143


Contents

Contents

The Present Value of an Uneven Stream 144

Perpetu ities 145

The Multinational Firm: The Time Value of Money 145

Summary 147' Key Terms 147' Review Questions 148' SelrTest Problems 148• Study Problems 148' Mini Case 154' Self-Test Solutions 155

6 The Meaning and Measurement of Risk and Return 156Expected Return Defined and Measured 157

Can You Do It? Computing Expected Cash Flow and Expected Return 159

Risk Defined and Measured 159

Did You Get It? Computing Expected Cash Flow and Expected Return 160

Can You Do It? Computing the Standard Deviation 163

Finance at Work A Different Perspective of Risk 163

Ethics in Financial Management "I Should Have Said No" 164

Did You Get It? Computing the Standard Deviation 165

Rates of Return: The Investor's Experience 165

Finance at Work Hard Lessons 166

Risk and Diversification 167

Diversifying Away the Risk 167Measuring Market Risk 168

Can You Do It? Estimating Beta 172

Measuring a Portfolio's Beta 173

Did You Get It? Estimating Beta 174

Risk and Diversification Demonstrated 174

The Investor's Required Rate of Return 175

The Required Rate of Return Concept 176Measuring the Required Rate of Return 176

Finance at Work Does BE;!taAlways Work? 177

Can You Do It? Computing a Required Rate of Return 178

Did You Get It? Computing a Required Rate of Return 179

Summary 179' KC1)Terms 179' Review Questious 180' Self-Test Problems 180• Study Problems 181' Miui Case 184' Selj~Test Solutions 186

7 The Valuation and Characteristics of Bonds 188Types of Bonds 189

Debentures 189Subordinated Debentures 190Mortgage Bonds 190Eurobonds 190Convertible Bonds 190

Finance at Work Alcoa: How to Raise $1.5 Billion Ahead of Weak Earnings 191

Terminology and Characteristics of Bonds 191

Claims on Assets and Income 192Par Value 192Coupon Interest Rate 192Maturity 192Call Provision 192Indenture 193Bond Ratings 193

Finance at Work Clear Channel Rating Is Cut 194

Defining Value 194

What Determines Value? 195


Valuation:The Basic Process 196

Can You Do It? Computing an Asset's Value 197

Valuing Bonds 197

Did You Get It? Computing an Asset's Value 199

Can You Do It? Computing a Bond's Value 200

Did You Get It? Computing a Bond's Value 201

Bond Yields 201

Yield to Maturity 201Current Yield 202

Bond Valuation: Three Important Relationships 202

Can You Do It? Computing the Yield to Maturity and Current Yield 203

Did You Get It? Computing the Yield to Maturity and Current Yield 204

Summary 206· .Key Terms 207· Review Questions 207· Self-Test Problems 208• Studtf Problems 208· Mini Case 210· SelF Test Solutious 210

8 The Valuation and Characteristics of Stock 21 2Preferred Stock 214

The Characteristics of Preferred Stock 214

Valuing Preferred Stock 215

Finance at Work Reading a Stock Quote in the Wall Street Journal 217

Can You Do It? Valuing Preferred Stock 217

Did You Get It? Valuing Preferred Stock 218

Common Stock 218

The Characteristics of Common Stock 218

Finance at Work Does Stock by Any Other Name Smell as Sweet? 219

Valuing Common Stock 220

Cautionary Tale Forgetting Principle 4-Market Prices Are Generally Right 222

Can You Do It? Measuring Johnson & Johnson's Growth Rate 222

Did You Get It? Measuring Johnson & Johnson's Growth Rate 224

Can You Do It? Calculating Common Stock Value 224

The Expected Rate of Return of Stockholders 225

The Expected Rateof Return of Preferred Stockholders 225

Did You Get It? Calculating Common Stock Value 225

The Expected Rateof Return of Common Stockholders 226

Can You Do It? Computing the Expected Rate of Return 227

Did You Get It? Computing the Expected Rate of Return 227

Summary 228· .Key Terms 229· Review Questiolls 229· Self-Test Problems 230• Study Problems 230· Mini Case 232· Self-Test Solutions 232

9 The Cost of Capital 234The Cost of Capital: Key Definitions and Concepts 235

Opportunity Costs,Required Ratesof Return,and the Cost of Capital 235

Can You Do It? Determining How Flotation Costs Affect the Cost of Capital 236

The Firm'sFinancial Policy and the Cost of Capital 236

Determining the Costs of the Individual Sources of Capital 236

The Cost of Debt 237

Did You Get It? Determining How Flotation Costs Affect the Cost of Capital 237

The Cost of Preferred Stock 238The Cost of Common Equity 239The Dividend Growth Model 239


Contents

Contents

Can You Do It? Calculating the Cost of Debt Financing 240

Can You Do It? Calculating the Cost of Preferred Stock Financing 240

Did You Get It? Calculating the Cost of Debt Financing 241

Did You Get It? Calculating the Cost of Preferred Stock Financing 241

Issues in Implementing the Dividend Growth Model 241The Capital Asset Pricing Model 242Issues in Implementing the CAPM 242

Can You Do It? Calculating the Cost of New Common Stock Using the DividendGrowth Model 243

Can You Do It? Calculating the Cost of Common Stock Using the CAPM 243

Finance at Work IPOs: Should a Firm Go Public? 244

The Weighted Average Cost of Capital 245

Did You Get It? Calculating the Cost of New Common Stock Using the DividendGrowth Model 245

Did You Get It? Calculating the Cost of Common Stock Using the CAPM 245

Capital Structure Weights 246Calculating the Weighted Average Cost of Capital 246


Calculating Divisional Costs of Capital: PepsiCo Inc. 248

Can You Do It? Calculating the Weighted Average Cost of Capital 248

Finance at Work The Pillsbury Company Adopts EVA with a Grassroots EducationProgram 249

Did You Get It? Calculating the Weighted Average Cost of Capital 250

Using a Firm's Cost of Capital to Evaluate New Capital Investments 251

Finance at Work Weighted Average Costs of Capital Estimates: 1993-2005 252

Finance and the Multinational Firm:Why Do Interest Rates Differ BetweenCountries? 253

Can You Do It? Evaluating Interest Rate Parity Across Countries 253

Did You Get It? Evaluating Interest Rate Parity Across Countries 254

Summary 255· Key Terms 256· Review Questious 257· Self-Test Problems 257• Study Problems 258· Mini Case 260· Selj~ Test Solutions 261

milD Investment in Long-TermAssets 264

10 Capital-Budgeting Techniques and Practice 264Finding Profitable Projects 265

Cautionary Tale Forgetting Principle 3: Risk Requires a Reward and Principle 4:Market Prices Are Generally Right 266

Capital-Budgeting Decision Criteria 267

The Payback Period 267The Net Present Value 268Using Spreadsheets to Calculate the Net Present Value 271

Can You Do It? Determining the NPVof a Project 271

The Profitability Index (Benefit-Cost Ratio) 272

Did You Get It? Determining the NPV of a Project 273

The Internal Rate of Return 274

Can You Do It? Determining the JRR of a Project 276

Viewing the NPV-IRR Relationship:The Net Present Value Profile 277

Did You Get It? Determining The IRR of a Project 277

Complications with the IRR: Multiple Rates of Return 278The Modified Internal Rate of Return (MIRR)3 279Using Spreadsheets to Calculate the MIRR 281


Capital Rationing 282

The Rationale for Capital Rationing 282Capital Rationing and Project Selection 283

Ranking Mutually Exclusive Projects 284

The Size-Disparity Problem 284The Time-Disparity Problem 285The Unequal-Lives Problem 286

Ethics in Financial Management The Financial Downside of Poor EthicalBehavior 289

Ethics in Capital Budgeting 289

A Glance at Actual Capital-Budgeting Practices 289

Finance and the Multinational Firm: Capital Budgeting 290

Summary 291 • Key Terms 293· Review Questions 293· Self- Test Pmblems 294• Study Problems 294· Milli Case 299· Selj~ Test Solutioll 301

11 Cash Flows and Other Topics In Capital Budgeting 302Guidelines for Capital Budgeting 302

Use Free Cash Flows Rather than Accounting Profits 303Think Incrementally 303Beware of Cash Flows Diverted from Existing Products 304Look for Incidental or Synergistic Effects 304Work in Working-Capital Requirements 304Consider Incremental Expenses 305RememberThat Sunk Costs Are Not Incremental Cash Flows 305Account for Opportunity Costs 305Decide If Overhead Costs Are Truly Incremental Cash Flows 305Ignore Interest Payments and Financing Flows 305

Finance at Work Universal Studios 306

An Overview of the Calculations of a Project's Free Cash Flows 306

What Goes Into the Initial Outlay 306What Goes Into the Annual Free Cash Flows over the Project's Life 307What Goes Into the Terminal Cash Flow 308Calculating the Free Cash Flows 309A Comprehensive Example: Calculating Free Cash Flows 312

Can You Do It? Calculating Operating Cash Flows 312

Did You Get It? Calculating Operating Cash Flows 313

Can You Do It? Calculating Free Cash Flows 315

Options in Capital Budgeting 315

Did You Get It? Calculating Free Cash Flows 316

The Option to Delay a Project 316The Option to Expand a Project 317The Option to Abandon a Project 317Options in Capital Budgeting:The Bottom Line 317

Risk and the Investment Decision 318

What Measure of Risk Is Relevant in Capital Budgeting' 318Measuring Risk for Capital-Budgeting Purposes with a Dose of Reality-Is Systematic Risk

All There Is? 320

Incorporating Risk Into Capital Budgeting 320

Risk-Adjusted Discount Rates 321Measuring a Project's Systematic Risk 322Using Accounting Data to Estimate a Project's Beta 323The Pure Play Method for Estimating Beta 323

Examining a Project's Risk through Simulation 324

Simulation: Explained and Illustrated 324Conducting a Sensitivity Analysis through Simulation 325


Contents

I Contents

Finance and the Multinational Firm: Calculating Cash Flows Amid theInternational Dimension of Risk 326

Summary 327· Ketj Terms 327· Review Questions 328· Self-Test Problems 328• Study Problems 329· Mini Case 333· Self-Test Solution 335

Capital Structure and Dividend Policy 336

12 Determining the Financing Mix 336Business and Financial Risk 338

Business Risk 339Operating Risk 339

Break-Even Analysis 340

Essential Elements of the Break-Even Model 340Finding the Break-Even Point 342The Break-Even Point in Sales Dollars 342

Can You Do It? Analyzing the Break-Even Sales Level 343

Operating Leverage 343

Did You Get It? Analyzing the Break-Even Sales Level 344

Can You Do It? Analyzing the Effects of Operating Leverage 344

Did You Get It? Analyzing the Effects of Operating Leverage 345

Can You Do It? Analyzing the Effects of Financial Leverage 345

Did You Get It? Analyzing the Effects of Financial Leverage 346

Financial Leverage 346

Can You Do It? Analyzing the Combined Effects of Operating and FinancialLeverage 347

Did You Get It? Analyzing the Combined Effects of Operating and FinancialLeverage 348

Combining Operating and Financial Leverage 348

Finance at Work When Financial Leverage Proves to Be Too Much to Handle 349

Planning the Financing Mix 350


A Quick Look at Capital Structure Theory 3S2The Importance of Capital Structure 352Independence Position 352The Moderate Position 354

The Moderate View:The Saucer-Shaped Cost-of-Capital Curve 355

Firm Value and Agency Costs 356

Agency Costs, Free Cash Flow, and Capital Structure 358Managerial Implications 358

The Basic Tools of Capital Structure Management 359

EBIT-EPS Analysis 359Comparative Leverage Ratios 362Industry Norms 362A Glance at Actual Capital Structure Management 363

Finance at Work Capital Structures Around the World 365

Summary 366· Key Terms 367· Review Questions 367· Self-Test Problems 367• Study Problems 368· Mini Case 369· Self-Test Solutions 371

13 Dividend Policy and Internal Financing 372Key Terms 373

Does a Firm's Dividend Policy Affect the Company's Stock Price? 374

Three Basic Views 374Improving Our Thinking 376What Are We to Conclude? 379


The Dividend Decision in Practice 380

Legal Restrictions 380Liquidity Constraints 380Earnings Predictability 380Maintaining Ownership Control 380

Alternative Dividend Policies 380

Dividend Payment Procedures 381

Stock Dividends and Stock Splits 382

Stock Repurchases 383

A Share Repurchase as a Dividend Decision 383The Investor's Choice 384A Financing or Investment Decision? 384

Finance at Work Companies Increasingly Use Share Repurchases to Distribute Cashto Their Stockholders 385

Practical Considerations-The Stock Repurchase Procedure 385

Summary 386' Key Terms 387' Review Questions 387' Self-Test Problems 388• Study Problems 388' Milli Case 389' Seif- Tl'st So/utiolls 391

Em Working-Capital Management and InternationalBusiness Finance 392

14 Short-Term Financial Planning 392Financial Forecasting 393

The Sales Forecast 393Forecasting Financial Variables 393The Percent of Sales Method of Financial Forecasting 394Analyzing the Effects of Profitability and Dividend Policy on DFN 396Analyzing the Effects of Sales Growth on a Firm's DFN 396

Can You Do It? Percent of Sales Forecasting 397

Did You Get It? Percent of Sales Forecasting 398

limitations of the Percent of Sales Forecasting Method 399

Constructing and Using a Cash Budget 400

Budget Functions 400

Ethics in Financial ManagementTo Bribe or NotTo Bribe 401

The Cash Budget 401

Ethics in Financial Management Being Honest About the Uncertaintyof the Future 402

Summary 403' Key Terms 403' Review Questiolls 403' Self-Test Problems 403• Study Problems 405' Mini Case 409' Self-Test Solutions 410

15 Working-Capital Management 412Managing Current Assets and liabilities 413

The Risk-Return Trade-Off 413The Advantages of Current Liabilities: Return 414The Disadvantages of Current Liabilities: Risk 414

The Appropriate Level of Working Capital 415

The Hedging Principles 415Permanent and Temporary Assets 415Temporary, Permanent, and Spontaneous Sources of Financing 416The Hedging Principle: A Graphic Illustration 416


The Cash Conversion Cycle 418

Can You Do It? Computing the Cash Conversion Cycle 418

Did You Get It? Computing the Cash Conversion Cycle 419

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J Keown, John D. Martin, and J. IMlliam Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

Contents

Contents

Estimating the Cost of Short-Term Credit Using the ApproximateCost-of-Credit Formula 420

Can You Do It?The Approximate Cost of Short-Term Credit 421

Sources of Short-Term Credit 421

Unsecured Sources:Accrued Wages and Taxes 421

Did You Get It?The Approximate Cost of Short-Term Credit 421

Finance at Work Managing Working Capital by Trimming Receivables 422

Can You Do It?The Cost of Short-Term Credit (Considering CompoundingEffects) 423

Unsecured Sources:TradeCredit 423

Did You Get It?The Cost of Short-Term Credit (Considering CompoundingEffects) 424

Unsecured Sources:BankCredit 424Unsecured Sources:Commercial Paper 426Secured Sources:Accounts-Receivable Loans 427Secured Sources:Inventory Loans 429

Multinational Working-Capital Management 429

Summary 430' Key Terms 430' Review Questions 431 • Self-Test Problems 431• Study Problems 432' Self-Test Solutions 435

16 Current Asset Management 436Why a Company Holds Cash 437

The CashFlow Process 437Motives for Holding Cash 438

Cash Management Objectives and Decisions 439

The Risk-Return Trade-Off 439Objectives 440Decisions 440

Collection and Disbursement Procedures 440

Managing the Cash Inflow-Speeding Up Collections 440The Lockbox Arrangement 441Managing the CashOutflow-Slowing Down Disbursements 442Evaluating the Costsof CashManagement Services 444

Can You Do It? Evaluating the Cost of Cash Management Services 444

The Composition of a Marketable-Securities Portfolio 444

Did You Get It? Evaluating the Cost of Cash Management Services 445

General Selection Criteria 445Marketable-Security Alternatives 448

Accounts-Receivable Management 449

The Terms of Sale-A Decision Variable 450The Type of Customer-A Decision Variable 451The Collection Effort-A Decision Variable 452

Inventory Management 452

Types of Inventory 453Inventory Management Techniques 454

Can You Do It? Calculating the Economic Order Quantity 455

Did You Get It? Calculating the Economic Order Quantity 457

Summary 458' Key Terms 459' Review Questiolls 459' Self-Test Problems 460• Study Problems 460' Mini Case 464' Self-Test Solutions 465

17 International BusinessFinance 466The Globalization of Product and Financial Markets 467

Exchange Rates 468

Floating Exchange Rates 468The Foreign Exchange Market 468


Spot Exchange Rates 469Exchange Rates and Arbitrage 471Asked and Bid Rates 471Cross Rates 471

Can You Do It? Using the Spot Rate to Calculate a Foreign Currency Payment 471

Forward Exchange Rates 472

Did You Get It? Using the Spot Rate to Calculate a Foreign Currency Payment 472

Can You Do It? Computing a Percent-Per-Annum Premium 474

Exchange Rate Risk 474

Did You Get It? Computing a Percent-Per-Annum Premium 475

Interest Rate Parity 475

Purchasing-Power Parity Theory 476

The Law of One Price 477The International Fisher Effect 477

Exposure to Exchange Rate Risk 478

Translation Exposure 478Transaction Exposure 479Economic Exposure 481

Multinational Working-Capital Management 481

Leading and Lagging Strategies 482Cash Management and the Positioning of Funds 482

International Financing and Capital Structure Decisions 482

Direct Foreign Investment 483

Business Risk and Financial Risk 484Political Risk 484Exchange Rate Risk 484

Summary 485· Key Terms 486· Review Questions 486· Self~Test Problems 487• Study Problems 487· Mini Case 488· Self-Test Solution 489

Appendix A: Using a Calculator 491

Glossary 503

Indexes 512

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition, by Arthur J Keown, John D. Martin, and J. William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

Contents


PrefaceThe study of finance focuses on making decisions that enhance the value of the firm. Thisis done by providing customers with the best products and services in a cost-effective way.In a sense we, the authors of Foundatio77s ojFiml11ce, are trying to do the same thing. That is,we have tried to present the study of financial management in a way that makes your studyas easy and productive as possible by using a step-by-step approach to walking you througheach new concept or problem.

We are very proud of the history of this volume as it was the first "shortened book" offinancial management when it was published in its first edition. The book broke new groundby reducing the number of chapters down to the foundational materials and by trying to pre-sent the subject in understandable terms. \IVe continue our quest for readability with theSeventh Edition.

Pedagogy That Works

Principle 1: Cash Flow Is What Matters

Five Principles that Form the Foundationsof Finance

You prob3hly rec-'(ll]from your accounting classes thata company's profit,> Clll differ dr:lmat-ieally from its cash tlows which we will review in Chapter 3. But for now understand thatc:Ish tlows, not profits. represent money that C1I1 be spent. Consequently, i[ is c<1sh!low, nOtprotlts that determines the value of a business. For this n:;1S0n when we analvzc [he consc-quenccs of a m.anagerial dccisio~ we focu~.on the rt:sl.Jlting cash flows, noty~ofi[s.

'nJ the first-time snJdent of fin~nce, the subject lTI;}tter In<lV stem like :l collection of unre-bred decision rules. This could not be further fi'orn the trutil. In fact, our decision rules, :lndthe logic that underlies them, spring from tIn: simple principles that do not n:quin.: knowl-olgc of fin:mce to understand. These five principles guide the fin<lnt'i::J1IRlOager in thecn.::.ltion of "ulue for the firm's owners (the stockholders).

As you will sec, while it is not necessary to lllH]crstancJ fin3ncc ro undcrs(3nd these prin-ciples, it is necessary to underst;1nd these principles in order 1"0 understand finance. Al-though these principles Im)";lt first 3ppe,lr simple or even trivial, thlT provide the drivingforce hehind all that follows, we3ving together the concepts ::Jndtechniques presented in (histext. and thereby allowing us to focus on the logic underlying the practice of tlnancl3l n13n-

agerncnt. Now let's inl"HHillcc the five principles.

~2 Understand the five basic~ principles of finance and

business. the consequencesof forgetting those basicprinciples of finance, and theimportance of ethics and trustin business.

This book provides students with a conceptual understanding of the financial decision-making process, rather than just an introduction to the tools and techniques of finance. Forthe student, it is all too easy to lose sight of the logic that drives finance and focus insteadon memorizing formulas and procedures. As a result, students have a difficult time under-standing the interrelationships among the topics covered. Moreover, later in life when theproblems encountered do not match the textbook presentation, students may find them-selves unprepared to abstract from what they learned. To overcome this problem, the open-ing chapter presents 5 underlying principles of finance, which serve as a springboard for thechapters and topics that follow. In essence, the student is presented with a cohesive, inter-related perspective from which future problems can be approached.

\iVith a focus on the big picture, we pro-vide an introduction to financial decisionmaking rooted in current financial theoryand in the current state of world economicconditions. This focus is perhaps most ap-parent in the attention given to the capitalmarkets and their influence on corporate fi-nancial decisions.\Vhat results is an intro-ductory treatment of a discipline ratherthan the treatment of a series of isolatedproblems that face the financial manager.The goal of this text is not merely to teachthe tools of a discipline or trade but also toenable students to abstract what is learnedto new and yet unforeseen problems-inshort, to educate the student in finance.

Innovations and Distinctive Featuresin the Seventh Edition"Cautionary Tale" BoxesThese give students insights into how the core concepts of finance apply in the real world.Each "Cautionary Tale" box goes behind the headlines of finance pitfalls in the news to showhow one of the Five Principles was forgotten or violated.

xxiii

Foundations of Finance: The Logic and Practice of Financial Management. Seventh Edition, by Arthur J. Keown. John D. Martin. and J. William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

Preface

Real-World Opening VignettesEach chapter begins with a story about a current, real-world company faced with a financialdecision related to the chapter material that follows. These vignettes have been carefullyprepared to stimulate student interest in the topic to come and can be used as a lecture toolto provoke class discussion.

New and Improved Problem SetsThe end-of-chapter study problem sets have been improved and expanded to allow for awider range of student problems.

Use of an Integrated learning SystemThe text is organized around the learning objectives that appear at the beginning of eachchapter to provide the instructor and student with an easy-to-use integrated learning system.Numbered icons identifying each objective appear next to the related material throughoutthe text and in the summary, allowing easy location of material related to each objective.

CAN YOU DO IT?SOLVING FOR THE REAL RATE OF INTERESTYour banker just called and offered you the chance to invest your savings for 1 year at a quoted rate of 10 percent. You also saw on thenews that the inflation rate is 6 percent. What is the real rate of interest you would be earning if you made the investment? (The solu-tion can be found on page 38.)

DID YOU GET IT?SOLVING FOR THE REAL RATE OF INTEREST

u Do It?" Nominal or quoted = real rate of + inflation .,. product of the real rate of

veral pages rate of interest interest rate interest and the inflation rate

an essential0.10 ~ (real rate of + 0,06 + 0.06 X real rate of interest

interest)

pproach to 0.04 - 1.06 X (real rate

of interest)

Solving for the real rate of interest:

(real rate of interest) = 0.0377 ~ 3.77%

"Can You Do It?" and"Did You Get It?"The text provides examples forthe students to work at the con-clusion of each major section of achapter, which we call, "Can Yofollowed by "Did You Get It?" selater in the text. This tool providesingredient to the building-block athe material that we use.

Concept Check1. According to Principle 3, how do investors decide where to invest their money)

2. "Vhat is an efficient market)

3. 'What is the,

4. \\Thy are eth .,a·,!~'a·ii.Firms A and B arc idcntical in size. Both have SI,OOOin total assets, and both have an oper-ating return on assets of 14 percent. However, they are different in one respect: Firm A usesall equity and no debt financing; Firm B tinanccs 60 percent nfits investments with debt and40 percent with equity. (For the sake of simplicity, \VC will assume that both firms pay inter-est at an interest cost of 6 percent, <1I1dthere are no income taxes.) The fin<lJ1Cialstatementsfor the two companies would be as follows:

rld examples to FIRM A FIRM B

'sented ]n each BALANCE SHEET

Totalassets $1,000 $1,000Debt (6% interest rate) $0 'S6oOEquity -.l..QQQ ----.1QQTotal debt and equity $1,000 $1,000

INCOME STATEMENT

Operating income (OROA= 14%) $ 140 $ 140Interestexpense (6%) L-..Q) L-iO)Net income $ 140 ~

Concept CheckAt the end of most major sections,this tool highlights the key ideasjust presented and allows studentsto test their understanding of thematerial.

Integrated ExamplesThese provide students with real-wohelp them apply the concepts prechapter.


IPreface

ETHICS IN FINANCIAL MANAGEMENT

THE WALL STREETJOURNAL WORKPLACE-ETHICS QUIZExtensive Coverage of EthicsEthics is covered as a core principle and "Ethicsin Financial Management" boxes appearthroughout. These show students that ethicalbehavior is doing the right thing and that ethicaldilemmas are everywhere in finance.

Without question, when you enter the workforce you will be facedwith a number of ethical dilemmas that you have never consid-ered. The spread of technology into the workplace has raised avariety of new ethical questions, and many old ones still linger.The following is a quiz dealing with ethical questions that willboth give you some questions to think about and also allow youto compare your answers with those of other Americans surveyed.

Office Technologyt. Is it wrong to use company ernail for personal reasons?

Yes No

2. Is it wrong to play computer games on office equipmentduring the workday?Yes No

8. Can you accept a S75 prize won at a raffle at a supplier'sconference?Yes No

Truth and Lies9. Due to on-the-job pressure, have you ever abused or lied

about sick days?Yes No

10. Due to on-the-job pressure, have you ever taken credit forsomeone else's work or idea?

Yes No

Sources: Ethics Officer AssociatiOn. Belmont. Mass.; EthiCillleadership GrOllI'.Wilmette, III.;surveys sampled a cross-~tion of workef'5 at lafge companiesandnatiorlwide

3. Is it unethical to blame an error you made on a technologi-cal glitch?Yes No

Remember Your PrinciplesThese in-text inserts appear through-out to allow the student to take timeout and reflect on the meaning of thematerial just presented. The use ofthese inserts, coupled with the use ofthe 5 principles, keeps the studentfocused on the interrelationships andmotivating factors behind the concepts.

Gifts and Entertainment4. Is a $SO gift to a boss unacceptable?

n REMEMBER YOUR PRINCIPLESl..f;irtcipte In this chapter, we cover material that introduces thefinancial manager to the process involved in raising funds inthe nation's capital markets and how interest rates in thosemarkets are determined.

Without question the United States has a highly developed,complex, and competitive system of financial markets that al-lows for the quick transfer of savings from people and organi-zations with a surplus of savings to those with a savings deficit.Such a system of highly developed financial markets allowsgreat ideas (such as the personal computer) to be financed andincreases the overall wealth of the economy. Consider yourwealth, for example, compared to that of the average family inRussia. Russia lacks the complex system of financial markets tofacilitate securities transactions. As a result, real capital forma-tion there has suffered.

Thus, we return now to Principle 4: Market Prices Are Gen-erally Right. Financial managers like the U.S.system of capitalmarkets because they trust it. This trust stems from the fact thatthe markets are efficient, and so prices quickly and accuratelyreflect all available information about the value of the underly-ing securities. This means that the expected risks and expectedcash flows matter more to market participants than do simplerthings such as accounting changes and the sequence of pastprice changes in a specific security. With security prices and re-turns (such as interest rates) competitively determined, more fi-nancial managers (rather than fewer) participate in the marketsand help ensure the basic concept of efficiency.

)tbal1

Ethics Quiz Answers1. 34% said personal emall on company computers is

wrong2. 49% said playing computer games at work is wrong3. 61% said it's unethical to blame your error on technology4. 35% said a $50 gift to the boss is unacceptable5. 12%said a $50 gift from the boss is unacceptable6. 70% said it's unacceptable to take the $200 football

tickets7. 35% said it's unacceptable to take the $100 food basket8. 40% said it's unacceptable to take the $75 raffle prize9. 11% reported they lie about sick days

10. 4% reported they take credit for the work or ideas ofothers

Source: The Wall Street Joumal, October 21. 1999, page 81 {Copyright (:'1999,

Dow Jones & Compaoy. Inc.) All Rights Reserved

Financial CalculatorsThe use of financial calculators has been integratedthroughout this text, especially with respect to thepresentation of the time value of money. vVhere ap-propriate, calculator solutions appear in the margin.

rehensive Mini Case appears at the end of almost everycovering aU the major topics included in that chapter.

ini Case can be used as a lecture or review tool by theor. For the students, it provides an opportunity to applyconcepts presented within the chapter in a realistic set-ereby strengthening their understanding of the material.

prehensive End-of-Chapter ProblemsMini Case ComThe final stage in the irm;n'icw process for an assistant financial analyst at Caledonia Products in- Avolves a rest of you!' understanding of basic tlnancial concepts. You are given the following metno~ comprandum and asked TO respond to the q\HO'stions.\Vhcther yOll arc offcred a position atC:llcdonia \lyill chapter,depend on the accuracy of your response.

To: Applic:mts for the position of Financial Analyst This MFrom: Me \.~Morrison, CEO, Caledoni\l Products professRe: A test of your understanding of basic financial concepts and of the corporate tax code

Please respond to the following questions: all thell. n·11at is the appropriate goal for the firm and why? ring, thb. \Vhat does the risk-return trade-ofr mean?c. \Vhy arc we interested in cash flows rather than accounting profits in determining the value

of an asset?d. \Vhat is an efficiellt marker and what are rhe implications of efficient markets for us?c. \Vhat is the causc of the agency problcm and how do we tnr to solve it?f. Wllar do ethics and etbical behavior have to do with f11

g Dr;flnc (I) sole proprictorship, (2) partnership, and (3) CALCULATOR SOLUTION

Data Input Function Key

10 [&J6 om

-500 §]0 IPMTI

Function Key Answer

~IE] 279.20

Foundations of Finance: The Logic and Practice of Financial Management, Seventh Edition. by Arthur J. Keown, John D. Martin. and J William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

Preface

Content UpdatesIn response to both the continued development of financial thought and reviewer com-ments, changes have been made in the text. Some of these changes include:

Chapter 1An Introduction to the Foundations of Financial Management

• Updated and revised to make it as intuitive as possible.• The principles that form the Foundations of Finan_cewere simplified and consoLi-

dated from 10 principles down to 5 principles. In addition, a section titled AvoidingFinancial Crisis-Back to the Principles was introduced. This section examines eachof the principles individually and how ignoring them helped bring on the recentfinancial crisis.

• A new section on the importance of ethics and trust in financial management wasintroduced.

• In addition, new examples were added.

Chapter 2The Financial Markets and Interest Rates

• This chapter was significantly revised to reflect the recent changes in the financialmarkets.

• The chapter was simplified to make it livelier and more relevant to students.• A ne\v section titled The Financing of Business: The Movement of Funds Through the

Economy was added. This section illustrates the role of finance in our economy.• The discussion of investment banking was revised to reflect the dramatic impact of tlle

recent financial crisis on investment banking firms.GA Cautionary Tale-Forgetting Principle 5: Conflicts of Interest Cause Agency

Problems was introduced illustrating the impact of ignoring the principles of finance onthe recent financial crisis.

• The discussion of interest rates determinants was also simplified and made moreintuitive .

• This chapter was rewritten with an eye toward providing the student with need-to-know information that is used as building blocks to understand and introduce materialin subsequent chapters.

Chapter 3Understanding Financial Statements and Cash Flows

• A cautionary tale illustrating the peril of forgetting the principle that cash flows deter-mine value.

• A new Finance at Work drawing from a recent Fortune magazine article that highlightshow the world of finance may change as a result of tlle recent financial crisis.

• A presentation of Hewlett-Packard's financial statements to let a student see a real-world example.

• A.nimproved figure that visually presents the make-up of a balance sheet was added.• A totally new presentation of cash flows was added .., The addition of a new section explaining the relevance and computation of income

taxes was added.

Chapter 4Evaluating A Firm's Financial Performance

• A cautionary tale that shows the danger of forgetting the principle that risk requiresreward was added.

• A new Ethics in Financial Management that describes frequent rationalizations foracting unethically was added.


Chapter 5The Time Value of Money

• A new section on the use of timeJines to visuauze cash flows was added .• This chapter was revised with an eye toward making it more accessible to math-phobic

students.• Coverage of the time value of money tables was dropped.• Alternative approaches to solving time value of money problems were provided.• A Cautionary Tale-Forgetting Principle 3: Risk Requires a Reward and Principle 4:

Market Prices Are Generally Right was introduced.• An increased emphasis on the intuition behind the time value of money was provided

stressing visuaLizing and setting up the problem.

Chapter 6The Meaning and Measurement of Risk and Return

• The chapter provides an expanded presentation of holding-period returns to insure thatstudents understand the foundation concept of returns.

• ~Then explaining how to compute a standard deviation of returns, we developed a step-by-step approach instead of simply presenting an equation.

• There is a new Ethics in Financial Management box that tells the story of AaronBeam, fonner CFO of HealthSouth Corporation, who explains how he graduallyslipped in committing fraud, and what life is like for him today.

• The chapter offers a new presentation of risk and diversification, using Google as anexample.

• There is a new presentation in the chapter showing the relationship between risk andreturn and the length of the holding period.

Chapter 7The Valuation and Characteristics of Bonds

• This chapter has been revised to provide an updared explanation with examples of thenature and characterisrics of bonds.

• There are all new real-world examples of how to compute the value and expected ratesof returns of a bond.

ChapterSThe Characteristics and Value of Stocks

• The chapter presents a cautionary tale that lets a student see some of the foolish waysinvestors try to outperform the market, usually with disastrous results, suggesting thatPrinciple 4, Market Prices i\re Generally Right, is active and working.

• liVehave simplified the presentation of stock valuation that better fits the needs of a stu-dent in a beginning finance class.

Chapter 9The Cost of Capital

• This chapter was moved to appear before the discussion of capital budgeting .• The new placement provides a logical transition from the discussion of the determi-

nants of capital market rates of return in Chapter 8 to the application of this material tothe estimation of the firm's cost of capital.

• The plight of Goldman Sachs when the credit markets seized up in 2008 is used to illus-o"ate the volatile nature of a firm's cost of capital.

Foundations of Finance. The Logic and Practice of Financial Management. Seventh Edition. by Arthur J. Keown. John D. Martin, and J. William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

Preface •

Preface

Chapter 10Capital Budgeting Techniques and Practiceo Added coverage of the discounted payback period was included.• The number of worked out examples were increased in this chapter since this is one of

the key chapters in the book and one that traditionally provides students with a greatdeal of difficulty.

• Additional problems were added.

Chapter 11Cash Flows and Other Topics in Capital Budgeting

• The discussion of the calculation of a project's free cash flows was simplified and mademore intuitive in nature, while additional worked out problems were added to thechapter.

Chapter 12Determining the Financing Mix

• Increased the discussion linking operating, financial, and combined leverage.

Chapter 13Dividend Policy and Internal Financing

• Additional coverage of the practical considerations underlying the determination of afirm's dividend policy.

Chapter 14Short-Term Financing

• Increased emphasis on percent of sales forecasting as well as its inherent limitations.

Chapter 15Working Capital Management

• Revised discussion of the cash conversion cycle and its role in reducing a firm's invest-ment in working capital.

Chapter 16Current Asset Management

• Streamlined coverage of the methods used to speed up collections of accountsreceivable.

Chapter 17International Business Finance

• This chapter was revised and updated to reflect changes in exchange rates and in theglobal financial markets in general.

• The section on interest rate parity was streamlined and simplified.

A Complete Support Package for the Studentand Instructor

MyFinancelabThis fully integrated online homework system gives students the hands-on practice and tu-torial help they need to learn finance efficiently. Ample opportunities for online practice andassessment in MyFinanceLab are seamlessly integrated into each chapter. For more details,see the inside front cover.

Foundations of Finance: The Logic and Practice of Financial Management. Seventh Edition. by Arthur J. Keown. John D. Martin. and J. William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

Instructor's Resource CenterThis password-protected site is accessible at \vww.pearsonhighered.com/keown and hostsall of the instructor resources that follow. Instructors should click on the "Help Download-ing Instructor Resources" link for easy-to-follow instructions on getting access or may con-tact their sales represent'ltive for further information.

Test Item FileThis Online Test Item File, prepared by Alan D. Eastman ofIndiana University of Penn-sylvania, provides more than 1,600 multiple-choice, truelfalse, and short-answer questionswith complete and detailed answers. The online 'lest Item File is designed for use \vith the'IestGen-EQ test generating software. This computerized package allows instructors to cus-tom design, save, and generate classroom tests. The test program permits instructors to edit,add, or delete questions from the test bank; edit existing graphics and create new graphics;analyze test results; and organize a database of tests and student results. This new softwareallows for greater flexibility and ease of use. It provides many options for organizing and dis-playing tests, along with a search and sort feature.

Instructor's Manual with Solutions\iVritten by the authors, the Online Instructor's l\1anual follows the textbook's organiza-tion and represents a continued effort to serve the teacher in his or her goal of being ef-fective in the classroom. Each chapter contains a chapter orientation, an outline of eachchapter (also suitable for lecture notes), answers to end-of-chapter questions, and an ex-tensive problem set for each chapter, including a large number of alternative problemsalong with answers.

The Instructor's Manual is available electronically and instructors can download thisfile from the Instructor's Resource Center by visiting www.pearsonhighered.com/keown.

The PowerPoint lecture PresentationThis lecture presentation tool, prepared by Philip Samuel Russel of Philadelphia Univer-sity, provides the instructor with individual lecture outlines to accompany the text. Theslides include many of the figures and tables from the text. These lecture notes can be usedas is or instructors can easily modify them to reflect specific presentation needs.

Study GuideThe Study Guide to accompany Foundations of Finance: The Logic and Pmctice of Financialj'vIanagement, 7th Edition, was written by the authors with the objective of providing a stu-dent-oriented supplement to the text. Each chapter of the Study Guide cont,lins ,ll1orien-tation of each chapter along with a chapter outline of key topics; problems (with detailedsolutions) and self-tests, which can be used to aid in the preparation of outside assignmentsand in studying for exams; a tutorial on capital budgeting; and a set of tables that not onlygives compound sum and present value interest factors but also shows how to compute theinterest using a financial calculator.

Companion Website(www.pearsonhighered.comlkeown) The vVebsite contains vanous activities relatedspecifically to tlle Seventh Edition of FoundatiollI of Finance: Tbe Logic and Practice ofFinrl17-rial fvIrl7lagement.

ExcelSpreadsheetsCreated by the authors, these spreadsheets correspond with the end-of-chapter problemsfrom the text. This student resource is available on both the companion Website and1'\1yFinanceLab.

Foundations of Finance: The Logic and Practice of Financial Management. Seventh Edition. by Arthur J. Keown. John D. Martin. and J William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

Preface

http://www.pearsonhighered.com/keown.

http://www.pearsonhighered.comlkeown

Preface

CourseSmart for InstructorsCourseSmart goes beyond traditional teaching resources to provide instant, online access to thetextbooks and course materials you need at a lower cost to students. And while students savemoney, you can save time and hassle ",ritha digital textbook that allows you to search the mostrelevant content at the very moment you need it. v\!hether it's for evaluating textbooks or cre-,lting lecture notes to help students ,vith difficult concepts, CourseSmart can make life a littleeasier. See how by visiting the CourseSmart vVeb site at www.coursesmart.com/instructors.

CourseSmart for StudentsCourseSmart goes beyond traditional expectations providing instant, online access to the text-books and course materials students need at lower cost. Students can also search, highlight,and take notes anywhere at any time. See all the benefits to students at www.coursesmart.com/students.

Subscriptions

Analyzing current events is an important skill for economic students to develop. To sharpenthis skill and further support the book's theme of exploration and application, Prentice Halloffers you and your student's three news subscription offers:

The Wall Street Journal Print and Interactive EditionsSubscriptionPrentice Hall has formed a strategic alliance with the rVall Street Journal, the most respectedand trusted daily source for information on business and economics. For a small additionalcharge, Prentice Hall offers students a IS-week subscription to the H7all Street Journal In-teractive Edition (wsj.com) and a IS-week complimentary print edition subscription. Uponreceipt of 10 student registrations from an adopting institution, a professor can receive aone-year subscription of the print and interactive versions as well as weekly subject-specificf1Iall Street Journal educators' lesson plans.

The Financial TimesWe are pleased to ailliounce a special partnership with the Financial Times. For a small ad-ditional charge, Prentice Hall offers your students a IS-week subscription to the FinancialTimes. Upon adoption of a special package containing the book and the subscription book-let, professors will receive a free one-year subscription. Please contact your Prentice Hallrepresentative for details and ordering information.

Economist.comThrough a special arrangement with Economist.com, Prentice Hall offers your studentsa 12-week subscription to Economist.com for a small additional charge. Upon adoption of aspecial package containing the book and the subscription booklet, professors will receive afree six-month subscription. Please contact your Prentice Hall representative for furtherdetails and ordering information.


http://www.coursesmart.com/instructors.

http://www.coursesmart

Preface

John Kachurick, Nlisericordia UniversityOkan Kavuncu, University of California at Santa CruzGary Kayakachoian, Rbode Island CollegeLynn Phillips Kugele, University of MississippiMary LaPann, Adirondack Community CollegeCarlos Liard-Muriente, Central Connecticut State UniversityChristopher Liberty, College of St Rose, Empire State CollegeEdmund Mantell, Pace UniversityPeter Marks, Rhode Island CollegeMario Mastrandrea, Cleveland State UniversityAnna McAleer, Arcadia UniversityRobert Meyer, Parkland CollegeRonald Moy, St. John's UniversityElisa Muresan, Long Island UniversityAnthony Pondillo, Siena CollegeWalter Purvis, Coastal Carolina Community CollegeEmil Radosevich, Central New i'vlexico Community CollegeDeana Ray, Forsyth Technical Community CoLlegeClarence Rose, Radford UniversityAhmad Salam, \Videner UniversityJeffrey Schultz, Christian Brothers UniversityKen Shakoori, California State University, BakersfieldMichael Slates, Bowling Green State UniversitySuresh Srivastava, University of Alaska AnchorageMauny Tamarkin, Clark UniversityFang \Vang, \Vest Virginia UniversityPaul V\Tarrick,\Vestwood CoLlegeJill Wetmore, Saginaw Valley State UniversityKevin Yost, Auburn UniversityJingx-ue Yuan, Texas Tech UniversityMengxin Zhao, Bentley College

Acknowledgments,Ne gratefully acknowledge the assistance, support, and encouragement of those individualswho have contributed to the Seventh Edition of Foundations o/Finance. Specifically, we wishto recognize the very helpful insights provided by many of our colleagues. For their carefulcomments and helpful reviews of the text, we are indebted to:

Haseeb Ahmed, Johnson C. Smith UniversityJoan Anderssen, Arapahoe Community CoLlegeChris Armstrong, Draughons Junior CollegeCurtis Bacon, Southern Oregon UniversityDeb Bauer, University of OregonPat Bernson, County CoLlege of MonisEd Boyer, Temple UniversityJoe Brocato, Tarleton State UniversityJoseph Brum, Fayetteville Technical Community CollegeLawrence Byerly, Thomas More CollegeJanice Caudill, Auburn UniversityAndreas Christofi, Monmouth UniversityDavid Daglio, Newbury CollegeJulie Dahlquist, University of Texas at San AntonioDavid Darst, Central Ohio Technical CollegeMaria de Boyrie, New Mexico State UniversityKate Demarest, Carroll Community CollegeKhaled Elkhal, University of Southern IndianaCheri Etling, University of TampaCheryl Fetterman, Cape Fear Community CollegeDavid R. Fewings, Western vVashington UniversityDr. Charles Gahala, Benedictine UniversityHarry Gallatin, Indiana State UniversityDeborah Giarusso, University of Nortllern IowaGregory Goussak, University of Nevada, Las VegasLori Grady, Bucks County Community CollegeEd Graham, University of North Carolina \VilmingtonBarry Greenberg, Webster UniversityGary Greer, University ofIlouston DowntownBruce Hadburg, University of TampaThomas Hiebert, University of North Carolina, Charlotte}\1arlinJ emen, Auburn University

vVe also thank our friends at Prentice Hall. Vie offer our personal expression of appre-ciation to our editor-in-chief Donna Battista who provided the leadership and direction tothis project. vVewould also like to tlunk Tessa O'Brien, our finance editor. Tessa has been apleasure to work with, always full of ideas and driven to help us produce the best book pos-sible. vVewould also like to thank Sara Holliday, our project manager, for her adminisu'ativedefU1ess.\Vith Sara watching over us, there W,lS no W,lY the ball could be dropped. Our hatsare off to you, Sara. We would also like to extend our thanks to Heather McNally, who servedas our production supervisor; we express a very special thank you for seeing the book througha velY complex production process and keeping it all on schedule while maintaining ex-tremely high quality. Our thanks also go to Liz Averbeck for her marketing prowess. Liz hasan amazing understanding of the market, coupled with an intuitive understanding of wbatthe market is looking for. In addition to being a joy to work with, she is also the hardest work-ing person in America. Vie also thank Nicole Sackin, our media producer, who did a greatjob of making sure we are on the cutting edge in terms of web applications and offerings.

As a final word, we express our sincere thanks to those using Foundations 0/ Finance inthe classroom. \Ve thank you for making us a part of your team. Always feel free to give anyof us a call or contact us through the Internet when you have questions or needs.

-AJ.K./ ].D.i'\1./ ].W.P.

Foundations of Finance; The Logic and Practice of Financial Management, Seventh Edition, by Arthur J. Keown, John D. Martin, and J. William Petty.Published by Prentice Hall. Copyright © 2011 by Pearson Education, Inc.

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