Financial Management - GBVThe Role of Financial Intermediaries in U.S. Corporate Finance 396 The...

Financial Management

WILLIAM L. MEGGINSONDuke University

SCOTT B. SMARTIndiana University

JOHN R. GRAHAMUniversity of Oklahoma

SOUTH-WESTERNCENGAGE Learning-

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

Contents

About the Authors v

Preface vi

Objective and Primary Goals of this Edition vii

Organization of the Text x

' Major Improvements in the Third Edition xi

Chapter Content Improvements xii

The End Result xiii

Online Text Supplements -. xiv

Acknowledgments xviii

PART 1 Introduction

CHAPTER 1

The Scope of Corporate Finance 5

What Companies Do: Managing in a Financial Crisis 5

1.1 What Is Corporate Finance? 6

What Financial Managers Do 6

Smart Practices Video: Tom Cole, Co-Head, Global Banking, Deutsche Bank Securities 6

Smart Concepts 8

Smart Practices Video: Jeff Thermond, CEO, Woven Systems 9The Principles behind Managerial Decisions 9

1.2 Legal Forms of Business Organization 12Sole Proprietorships 12Partnerships 12Corporations 14Limited Liability Companies 16

1.3 Goals of the Corporate Financial Manager 16

What Should a Financial Manager Try to Maximize? 16

Smart Practices Video: Herbert Kelleher, Founder, Southwest Airlines 16

What Companies Do Globally: Views on Corporate Goals and Stakeholder Groups 18How Can Agency Costs Be Controlled in Corporate Finance? 19Why Ethics Are Important in Corporate Finance 20

Smart Ethics Video: Andy Bryant, Executive Vice President of Finance and Enterprise Services,Chief Administrative Officer, Intel Corp 20

Smart Solutions Problem 1-1 22

CHAPTER 2

Financial Statement and Cash Flow Analysis 24

What Companies Do: Financial Signs of a Slowing Economy 24

Smart Practices Video: Jon Olson, Chief Financial Officer, Xilinx Corp 25

2.1 Financial Statements 25Balance Sheet 26

What CFOs Do: CFO Survey Evidence 26

What Companies Do Globally: Assessing the Market Value of Global Brands 28Income Statement 30

Smart Practices Video: Steve Terronez, Finance Controller, Broadcom 30Statement of Retained Earnings 32

What CFOs Do: CFO Survey Evidence 32Statement of Cash Flows 33Notes to Financial Statements 33

2.2 Cash Flow Analysis 34The Firm's Cash Flows 34

Smart Practices Video: Greg Swearingen, VP, Investor Relations, Teradata Corp 34Developing the Statement of Cash Flows 37Interpreting the Statement 37

2.3 Assessing Financial Performance Using Ratio Analysis 39Using Financial Ratios 40Liquidity Ratios 40Activity Ratios 41

Smart Practices Video: Greg Barsch, President, Ravello Enterprises 41Debt Ratios 43Profitability Ratios 45

Smart Ethics Videos: Frank Popoff, Chairman of the Board (retired), Dow Chemical 46

Smart Concepts 47

Market Ratios 49





CHAPTER 3The Time Value of Money 66

What Companies Do: Take the Money and... Park? 66

Smart Practices Video: Jon Olson, Chief Financial Officer, Xilinx Corp 67

3.1 Future Value of a Lump Sum Received Today 67The Concept of Future Value 67

What Companies Do Globally: Taking It to the Bank 68The Equation for Future Value 69A Graphic View of Future Value 70

3.2 Present Value of a Lump Sum 71The Concept of Present Value 71The Equation for Present Value 72A Graphic View of Present Value 73

3.3 Future Value of Cash Flow Streams 73Finding the Future Value of a Mixed Stream 73Types of Annuities 75Finding the Future Value of an Ordinary Annuity 75Finding the Future Value of an Annuity Due 76

3.4 Present Value of Cash Flow Streams 78Finding the Present Value of a Mixed Stream 78

contents xxvn

Smart Practices Video: Cynthia Lucchese, Chief Financial Officer, Hillenbrand Industries 78

Finding the Present Value of an Ordinary Annuity 79Finding the Present Value of an Annuity Due 81Finding the Present Value of a Perpetuity 81 "*Finding the Present Value of a Growing Perpetuity 82

Smart Concepts 83

3.5 Special Applications of Time Value 83Compounding More Frequently Than Annually 84Stated versus Effective Annual Interest Rates 86Calculating Deposits Needed to Accumulate a Future Sum 88Loan Amortization 88Implied Interest or Growth Rates 90

Number of Compounding Periods 92







PART 2 Valuation, Risk, and Return

CHAPTER 4Valuation I l l

What Companies Do: Junk on TV I l l

4.1 Valuation Fundamentals 112The Fundamental Valuation Model 112

4.2 Bond Valuation 114The Basics of Bond Valuation 114Risk-Free Bonds 115Risky Bonds 119Bond Prices 122

Smart Practices Video: Tom Cole, Co-Head, Global Banking, Deutsche Bank Securities 123

4.3 Advanced Bond Valuation: The Term Structure of Interest Rates 126Evaluating the Yield Curve 126Term Structure Theories 127

4.4 Stock Valuation 130Preferred Stock Valuation 130

Smart Practices Video: Todd Richter, Managing Director, Bank of America 130

The Basic Common Stock Valuation Equation 131Zero Growth 133

. Constant Growth 134

Smart Concepts 134

Variable Growth 135How to Estimate Growth 137What If There Are No Dividends? 138

What Companies Do Globally: Factors That Influence U.S. Investors in Foreign Markets 139

Valuing the Enterprise: The Free Cash Flow Approach 140


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4.5 Other Approaches to Common Stock Valuation 143Book Value 143Liquidation Value 143Price/Earnings Multiples 144 ^

What Companies Do: How Investment Bankers Value Companies 145

Smart Ideas Video: Robert Shiller, Yale University 145






CHAPTER 5The Trade-off between Risk and Return 154

What Companies Do: You Want a Piece of Me? 154

5.1 Risk and Return Fundamentals 155A Historical Overview of Risk and Return 155

Smart Ideas Video: Elroy Dimson, London Business School 158

CFO Survey Evidence on the Equity Risk Premium 159Risk Aversion 161

Smart Ideas Video: Darrell Duffie, Stanford University 161

What Companies Do Globally: The Equity Risk Premium in the United States

and Europe (1900-2008) 162

5.2 Basic Risk and Return Statistics 164Return of a Single Asset 164Risk of a Single Asset 166

5.3 Risk and Return for Portfolios 169Portfolio Returns 169


Portfolio Variance: An Example 170

Smart Concepts 170

The Importance of Covariance 172Variance of a Two-Asset Portfolio 174

5.4 Systematic and Unsystematic Risk 177What Drives Portfolio Risk? 177

Smart Ethics Video: Utpal Bhattacharya, Indiana University 180

Measuring the Systematic Risk of an Individual Security 180Limitations of Beta 182

Smart Concepts 182





CHAPTER 6Risk, Return, and the Capital Asset Pricing Model 194

What Companies Do: Will the CAPM Cause a Train Wreck? 194

xxxii Contents

Competition and NPV 342

Strategic Thinking and Real Options 343





PART 4 Capital Structure and Payout Policy

CHAPTER 10Market Efficiency and Behavioral Finance 355

What Companies Do: Massive Short Squeeze Briefly Makes Volkswagen theWorld's Most Valuable Company 355

10.1 What Is an Efficient Financial Market? 356Definitions of Efficiency 356The Three Forms of Market Efficiency 357Does Empirical Evidence Support Market Efficiency? 357

Smart Ideas Video: Malcolm Baker, Harvard University 357

10.2 Empirical Evidence on Market Efficiency 359Tests for Return Predictability 359

Smart Ideas Video: Laura Starks, University of Texas 359

Tests for Rapid Price Adjustment 360Tests for Private Information 361

What Companies Do Globally: Mutual Fund Fees around the World 364

10.3 The Behavioral Finance Critique of Market Efficiency 367Bubbles, Fads, and Cascades: The Empirical Evidence on Behavioral Finance 367

Smart Concepts' 367

Smart Ideas Video: Robert Shiller, Yale University 368

Theoretical Underpinnings of Behavioral Finance 369Assessing Behavioral Finance and Market Efficiency 370

10.4 What Does Market Efficiency Imply for Corporate Financing? 371How Do Markets Process Accounting and Other Information Releases? 371How Do Markets Respond to Corporate Financing Announcements? 371


What Companies Do: CFO Survey Evidence on Disclosure Habits 372

How Can Managers Devise a Corporate "Communications" Policy? 373




CHAPTER 11An Overview of Long-Term Financing 385

What Companies Do: Barclays Bank Passes Up British Government Rescue 385

11.1 The Basic Instruments of Long-Term Financing 386Common Stock 386Preferred Stock 389Long-Term Debt 389 ;

Contents xxxiii

Smart Ideas Video: David Mauer, University of Texas, Dallas 391

11.2 The Basic Choices in Long-Term Financing 393The Need to Fund a Financial Deficit 393

What Companies Do Globally: What Do Private Pension Funds and Capital Markets Have in

Common? 394

The Choice between Internal and External Financing 395

11.3 The Role of Financial Intermediaries in Funding Corporate Investment 395What Is a Financial Intermediary, and What Does It Do? 396The Role of Financial Intermediaries in U.S. Corporate Finance 396The Corporate Finance Role of Non-U.S. Financial Intermediaries 397

11.4 The Expanding Role of Securities Markets in the Global Economy 398Overview of Securities Issues Worldwide 398

Smart Ethics Video: Kent Womack, Dartmouth College 400

Smart Practices Video: Frank Popoff, Chairman of the Board (retired), Dow Chemical 400

Merger and Acquisition Waves 40011.5 Law and Finance: The Importance of Corporate Governance 402

Law and Finance 402

CFO Survey Evidence: Factors Affecting Financing Decisions 404




CHAPTER 12Capital Structure: Theory and Taxes 412

What Companies Do: Changing Capital Structures 412

12.1 What Is Financial Leverage and What Are Its Effects? 413

Smart Practices Video: Mitchell Petersen, Northwestern University 416

12.2 The Modigliani & Miller Propositions 417

What Companies Do Globally: CFO Survey: The Importance of Capital Structure Decisions 417

Smart Practices Video: Keith Woodward, Vice President of Finance, General Mills 418

M&M Proposition I 418M&M Proposition II and the WACC 421

12.3 M&M and Taxes 423The M&M Model with Corporate Taxes 423The M&M Model with Corporate and Personal Taxes 425

What Companies Do Globally: Tax Factors in Emerging Markets 428

Smart Ideas Video: John Graham, Duke University 429

Nondebt Tax Shields 430

A Checklist of How Taxes Should Affect Capital Structure 430




CHAPTER 13Capital Structure: Balancing the Benefits and Costs of Debt 438

What Companies Do: Is What's Good for General Motors Good for America? 438

13.1 A Conceptual Framework for Trading OffDebt's Benefits and Costs 439Does Debt Policy Matter? 439

xxxiv Contents

Trading Off Debt's Benefits and Costs 439


13.2 Debt Tax Shields and Firm Profitability 442 ,

Smart Ideas Video: Scott Smart, Indiana University 442

13.3 Costs of Bankruptcy 443Direct and Indirect Bankruptcy Costs 443

Smart Practices Video: Tom Cole, Co-Head, Global Banking, Deutsche

Bank Securities 443

The Trade-off Model of Capital Structure 446

Smart Ideas Video: Robert Bruner, University of Virginia 447

Asset Characteristics and Bankruptcy Costs 447

Smart Ideas Video: Sheridan Titman, University of Texas 447

13.4 Agency Costs and Capital Structure 448Agency Costs of Outside Equity 448Using Debt to Overcome the Agency Costs of Outside Equity 449Agency Costs of Outside Debt 449The Trade-off Model Revisited 451


What Companies Do Globally: Target Capital Structure 452

13.5 The Pecking-Order Theory 453

Assumptions Underlying the Pecking-Order Theory 453


Smart Practices Video: Jon Olson, Chief Financial Officer, Xilinx Corp. 454

Evidence on the Pecking-Order and Trade-off Theories 45413.6 Signaling and Market-Timing Models 454

How Signaling with Capital Structure Can Convey Information 454

What Companies Do: CFO Survey Evidence 455

The Market-Timing Model 456

Smart Ideas Video: Malcolm Baker, Harvard University 456

13.7 Finding the Optimal Capital Structure for a Specific Company 456




CHAPTER 14The Link between Capital Structure and Capital Budgeting 466

What Companies Do: Investors Salivate over Performance Food Group 466

14.1 M&M, Capital Budgeting, and the WACC 467

14.2 The Adjusted Present Value Method 468

14.3 The Flow-to-Equity Method 470

What Companies Do Globally: CFO Survey Evidence 471

14.4 A Checklist for the Interactions between Investment and Financing Decisions 473



CHAPTER 15Payout Policy : 479

What Companies Do: Disappearing Dividends? 479

xxxvi Contents

Traditional Private Placements versus Rule 144A Issues 531

What CFOs Do: CFO Survey Evidence: Factors that Affect Stock Issuance Decisions 532

16.6 International Common Stock Offerings 533 *Non-U.S. Initial Public Offerings 533International Common Stock Issues 535Share Issue Privatizations 538

Smart Solutions Problem 16-1 541 . .

CHAPTER 17Long-Term Debt and Leasing 546

What Companies Do: GE Capital Issues AAA-Rated Bonds—at Junk Bond Rates 546

17.1 Characteristics of Long-Term Debt Financing 547The Choice between Public and Private Debt Issues 547Loan Covenants 548Cost of Long-Term Debt 549

17.2 Term Loans 550Characteristics of Term Loan Agreements 550

17.3 Corporate Bonds 552Popular Types of Bonds 552Legal Aspects of Corporate Bonds 552Methods of Issuing Corporate Bonds 555General Characteristics of a Bond Issue 555High-Yield Bonds 556International Corporate Bond Financing 557Bond Refunding Options 558

What Companies Do Globally: Islamic Finance: How Do You Sell Bonds When You Cannot Charge

Interest? 559

17.4 Syndicated Loans 564Specialized Syndicated Lending 564

What CFOs Do: How to Choose Debt Maturity: CFO Survey Evidence 566

17.5 Leasing 567Basic Types of Leases 567Lease Arrangements 568The Lease Contract 569The Lease-versus-Purchase Decision 569Effects of Leasing on Future Financing 571What Companies Do: Aircraft Leasing Hits Turbulent Skies 572

Advantages and Disadvantages of Leasing 573



PART 6 Options, Derivatives, and International FinancialManagement

CHAPTER 18Options Basics 587

What Companies Do: Berkshire Bets on Options 587


xxxviii Contents


APPENDIX 19A Estimating Volatility for the Black and Scholes Model 652

Smart Practices Video: Myron Scboles, Stanford University, and Chairman of Platinum Grove s

Asset Management 652

CHAPTER 20International Financial Management 654

What Companies Do: Currency Losses Compound Bad News 654

20.1 Exchange-Rate Fundamentals 655Fixed versus Floating Exchange Rates 655Exchange Rate Quotes 656The Foreign Exchange Market 660

20.2 Parity Conditions of International Finance 662Forward-Spot Parity 662Purchasing Power Parity 664Interest-Rate Parity 666Real Interest-Rate Parity (the Fisher Effect) 668The Asset Market Model of Exchange Rates 669

20.3 Managing Financial, Economic, and Political Risk 670

What Companies Do Globally: CFO Survey Evidence 672

Translation and Economic Risk 674Political Risk 674

Smart Practices Video: Herbert Kelleher, Founder, Southwest Airlines 674

Smart Ideas Video: Mara Faccio, Purdue University 675

20.4 Long-Term Investment Decisions S 675Capital Budgeting 675Cost of Capital 677

20.5 Short-Term Financial Decisions 678Cash Management 678

Credit and Inventory Management 680




PART 7 Short-Term Financing Decisions

CHAPTER 21Strategic and Operational Financial Planning 691

What Companies Do: Dell's Challenges and Plans 691

Smart Practices Video: Jackie Sturm, Director of Finance for Technology and

Manufacturing, Intel Corp. 692

21.1 Overview of the Planning Process 692Successful Long-Term Planning 692

What Companies Do Globally: How Companies Adjust Financial Plans When a Global

Recession Hits 693

The Role of Finance in Long-Term Planning 696

21.2 Planning for Growth 697-

Contents xxxix

Sustainable Growth 697

Pro Forma Financial Statements 701

Smart Practices Video: John Eck, President of Broadcast and Network Operations, NBC 702

21.3 Planning and Control 706Short-Term Financing Strategies 706

The Cash Budget 709

Smart Concepts 709




CHAPTER 22Cash Conversion, Inventory, and Receivables Management 726

What Companies Do: Apple's Superior Cash Conversion Creates

Huge Cash Balances 726

Smart Finance: Use the learning tools at www.cengage.com/international 727

Smart Practices Video: Vern LoForti, Chief Financial Officer, Overland Storage Inc. 727

Smart Practices Video: Jackie Sturm, Director of Finance for Technology and Manufacturing,

Intel Corp. 727

22.1 The Cash Conversion Cycle 729Operating Cycle 729Cash Conversion Cycle 730Shortening the Cash Conversion Cycle 731

22.2 Cost Trade-offs in Short-Term Financial Management 732

Smart Concepts 733

22.3 Inventory Management 734Investing in Inventory 735Techniques for Controlling Inventory 735

Smart Practices Video: Vern LoForti, Chief Financial Officer, Overland Storage Inc. 736

22 A Accounts Receivable Standards and Terms 738Effective Accounts Receivable Management 738Credit Standards 739

What Companies Do: A Working Capital Survey 740Credit Terms 746

22.5 Collecting, Monitoring, and Applying Cash to Receivables 747Collection Policy 748Credit Monitoring 748Cash Application 751




CHAPTER 23Liquidity Management 763

What Companies Do: The Electronic Payment Revolution?. 763

23.1 Cash Management 764Float 765

xl Contents

Cash Position Management 766

23.2 Collections 767Types of Collection Systems 767 ,

What Companies Do Globally: How Companies Finance Working Capital

Needs with Lines of Credit 768

Lockbox Systems 771

Smart Practices Video: Daniel Carter, former Chief Financial Officer of Charlotte Russe 772

Cash Concentration 772Funds Transfer Mechanisms 772

23.3 Accounts Payable and Disbursements 774Overview of the Accounts Payable Process 774Cash Discounts 774

Smart Concepts 775

Disbursement Products and Methods 775Developments in Accounts Payable and Disbursements 777

23.4 Short-Term Investing and Borrowing 778Short-Term Investing 778

Smart Practices Video: Scott Frame, Federal Reserve Bank of Atlanta 780

Smart Concepts 782

Short-Term Borrowing 782

What CFOs Do: CFO Survey Evidence on Bank Lines of Credit 783




PART 8 Special Topics

CHAPTER 24

Mergers, Corporate Control, and Corporate Governance 797What Companies Do: The Deal That Might Have Been—BHP Billiton's Bid for RioTinto Collapses 797

24.1 Overview of Corporate Control Activities 798Corporate Control Transactions 798LBOs, MBOs, and Dual-Class Recapitalizations 799Tender Offers, Acquisitions, and Proxy Fights 800Divestitures and Spin-offs 803

24.2 Horizontal, Vertical, and Conglomerate Mergers 803Horizontal Mergers 803Vertical Mergers 804Conglomerate Mergers 805Other Concentration Classifications 806

24.3 Merger and Acquisition Transaction Characteristics 808Method of Payment 808Accounting Treatment 809Shareholder Wealth Effects and Transaction Characteristics 810International Mergers and Acquisitions 813

24.4 Rationale and Motives for Mergers and Acquisitions 814Value-Maximizing Motives 815Synergy, Market Power, and Strategic Mergers 815

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Financial Management - GBVThe Role of Financial Intermediaries in U.S. Corporate Finance 396 The...

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