FinancialManagementPrinciples and Practice
Third Edition
Timothy J. GallagherProfessor of FinanceColorado State University
H Prentice ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ H• Hall ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ |
Prentice HallUpper Saddle River, NJ 07458
/ Joseph D. Andrew, Jr.Senior Financial AnalystBIA Financial Network, Inc.
Contents
Preface xxiAbout the Authors xxxi
Parti THE WORLD OF FINANCE xxxii
Finance and the Firm 2THE FIELD OF FINANCE 4
Finance Career Paths 5
FINANCIAL MANAGEMENT 5
The Role of the Financial Manager 5
Finance at Work: Brad Ford, Senior Accountant—Inventory Control for Eagle FoodCenters 6
THE BASIC FINANCIAL GOAL OF THE FIRM 8
In Search of Value 9
LEGAL AND ETHICAL CHALLENGES IN FINANCIAL MANAGEMENT 11
Agency Issues 12
Finance at Work: Melanie Rosen, Electronic Media, The New York Times 13
The Interests of Other Groups 13
The Interests of Society as a Whole 14
FORMS OF BUSINESS ORGANIZATION 15
The Proprietorship 15
The Partnership 16
The Corporation 17
Limited Liability Companies (LLCs) 18
WHAT'S NEXT 18Summary 19 • Self-Test 20 * Review Questions 20 •
Build Your Communication Skills 20 • Problems 21 •Answers to Self-Test 21
Financial Markets and Interest Rates 22THE FINANCIAL SYSTEM 24
Securities 24
Financial Intermediaries 25
FINANCIAL MARKETS 26
The Primary Market 26
The Secondary Market 26
The Money Market 26
The Capital Market 27
Security Exchanges 27
The Over-the-Counter (OTC) Market 27
Market Efficiency 28
u
SECURITIES IN THE FINANCIAL MARKETPLACE 28
Securities in the Money Market 28
Securities in the Capital Market 29
Ethical Connections: So. Calif Edison Hasn't Paid S395M of Commercial Paper 3
Financial Management and YOU: How to Buy Treasury Securities Without Using aBroker 33
INTEREST 33
Determinants of Interest Rates 34
The Yield Curve 36
WHAT'S NEXT 37
Summary 37 • Self-Test 39 • Review Questions 39 • Build YourCommunication Skills 39 • Problems 40 • Answers to Self-Test 41
Financial Institutions 42FINANCIAL INTERMEDIATION 44
Denomination and Maturity Matching 44
Absorbing Credit Risk 45
Commercial Banks 46
Bank Regulation 46
Commercial Bank Operations 46
Ethical Connections: How Ethical Is Your Financial Institution? 48
Online Banking 49
THE FEDERAL RESERVE SYSTEM 49
Organization of the Fed 50
Controlling the Money Supply 51
The Discount Window 52
SAVINGS AND LOAN ASSOCIATIONS 52
Legislation Affecting S&Ls 52
Regulation of S&Ls 53
Mutual Companies versus Stockholder-Owned Companies 53
The Problem of Matching Loan and Deposit Maturities 54
S&Ls' Real Assets 55
CREDIT UNIONS 55
The Common Bond Requirement 55
Members as Shareholders 55
Credit Unions Compared with Banks 55
Credit Union Regulation 56
FINANCE COMPANIES, INSURANCE COMPANIES, AND PENSION FUNDS 56Types of Finance Companies 56
Insurance Companies 57
Financial Management and YOU: The Social Security System 59
WHAT'S NEXT 59
Summary 59 • Self-Test 60 • Review Questions 61 • Build YourCommunication Skills 61 • Problems 61 • Answers to Self-Test 62
CONTENTS
/ ESSENTIAL CONCEPTS IN FINANCE 64
4 Review of Accounting 66REVIEW OF ACCOUNTING FUNDAMENTALS 68
BASIC ACCOUNTING FINANCIAL STATEMENTS 68
The Income Statement 68
Financial Management and YOU: A Special Earnings Category: EBITDA 71
Ethical Connections: Rite Aid Says SEC Has Begun Investigating the DrugstoreChain's Finances 72
The Balance Sheet 73
The Statement of Cash Flows 76
DEPRECIATION 79
Ethical Connections: Interview with Lynn Turner; Former Chief Accountant ofthe SEC 80
Calculating the Amount of Depreciation Expense 81
Financial Management and You: Your Personal Tax Rates 83
INCOME TAXES 83
WHAT'S NEXT 85
Summary 85 • Self-Test 85 • Review Questions 86 • Build YourCommunication Skills 87 • Problems 87 • Answers to Self-Test 92
5 Analysis of Financial Statements 94ASSESSING FINANCIAL HEALTH 96
Misleading Numbers 96
Financial Ratios 97
THE BASIC FINANCIAL RATIOS 98
Calculating the Ratios 99
Liquidity Ratios 103
TREND ANALYSIS AND INDUSTRY COMPARISONS 1 1 2
Finance at Work: Lee Anne Schuster, Kitchell Contractors, Marketing 113
Trend Analysis 113
Industry Comparisons 114
SUMMARY ANALYSIS: TREND AND INDUSTRY COMPARISONS TOGETHER 115
LOCATING INFORMATION ABOUT FINANCIAL RATIOS 117
WHAT'S NEXT 119
Summary 119 • Equations Introduced in This Chapter 120 •Self-Test 121 • Review Questions 121 • Build Your CommunicationSkills 122 • Problems 122 • Answers to Self-Test 133
6 Forecasting for Financial Planning 134WHY FORECASTING IS IMPORTANT 136
Forecasting Approaches 137
Why Forecasts Are Sometimes Wrong 137
FORECASTING SALES 138
CONTENTS
8
FORECASTING FINANCIAL STATEMENTS 139
Budgets 140
Producing Pro Forma Financial Statements 140
Analyzing Forecasts for Financial Planning 148
Finance at Work: Keith Ender, Customer Service Manager, James River PaperCompany 150
WHAT'S NEXT 151
Summary 151 • Self-Test 152 • Review Questions 152 • Build YourCommunication Skills 153 • Problems 153 • Answers to Self-Test 159
Risk and Return 160RISK 162
RISK AVERSION 162
THE RISK-RETURN RELATIONSHIP 162
MEASURING RISK 163
Using Standard Deviation to Measure Risk 163
Using the Coefficient of Variation to Measure Risk 168
THE TYPES OF RISKS FIRMS ENCOUNTER 169
Business Risk 169
Financial Risk 171
Portfolio Risk 172
DEALING WITH RISK 179
Risk-Reduction Methods 179
Financial Management and You: Mutual Funds and Risk 180
Compensating for the Presence of Risk 180
RELATING RETURN AND RISK: THE CAPITAL ASSET PRICING MODEL 181
WHAT'S NEXT 183
Summary 183 • Equations Introduced in This Chapter 185 •Self-Test 186 • FinCoach Practice Exercises 187 •Review Questions 187 • Build Your Communication Skills 187 •Problems 188* Answers to Self-Test 192
The Time Value of Money 194WHY MONEY HAS TIME VALUE 196
MEASURING THE TIME VALUE OF MONEY 196
The Future Value of a Single Amount 197
The Sensitivity of Future Values to Changes in Interest Rates or the Number ofCompounding Periods 200
THE PRESENT VALUE OF A SINGLE AMOUNT 200
The Sensitivity of Present Values to Changes in k and n 203
WORKING WITH ANNUITIES 204
Future Value of an Ordinary Annuity 204
The Present Value of an Ordinary Annuity 208
Ethical Connections: When a Million Isn't a Million. Taking a Chance on the TimeValue of Money 210
Future and Present Values of Annuities Due 210
Perpetuities 212
Present Value of an Investment with Uneven Cash Flows 212
XII CONTENTS
SPECIAL TIME VALUE OF MONEY PROBLEMS 214
Finding the Interest Rate 214
Finding the Number of Periods 217
Solving for the Payment 218
Loan Amortization 219
COMPOUNDING MORE THAN ONCE PER YEAR 220
WHAT'S NEXT 224Summary 224 * Equations Introduced in This Chapter 225 •
Self-Test 226 • FinCoach Practice Exercises 227 •Review Questions 227 • Build Your Communication Skills 228 •Problems 228 • Answers to Self-Test 233
Part III CAPITAL BUDGETING ANDBUSINESS VALUATION 234
9 The Cost of Capital 236- THE COST OF CAPITAL 238
SOURCES OF CAPITAL 238
The Cost of Debt 239
The Cost of Preferred and Common Stock Funds 240
The Weighted Average Cost of Capital (WACO 244
THE MARGINAL COST OF CAPITAL (MCC) 248
Finance at Work: Interview with Fred Higgins: Minit Mart Foods, Inc., CEO 249
The Firm's MCC Schedule 249
THE MCC SCHEDULE AND CAPITAL BUDGETING DECISIONS 253The Optimal Capital Budget 255
The Importance of MCC to Capital Budgeting Decisions 255
WHAT'S NEXT 256
Summary 257 • Equations Introduced in This Chapter 258 •Self-Test 259 • FinCoach Practice Exercises 260 • «Review Questions 260 • Build Your Communication Skills 260 •Problems 260 • Answers to Self-Test 265
10 Capital Budgeting Decision Methods 266THE CAPITAL BUDGETING PROCESS 268
Decision Practices 269
Types of Projects 269
Capital Budgeting Cash Flows 269
Stages in the Capital Budgeting Process 270
CAPITAL BUDGETING DECISION METHODS 270
The Payback Method 270
The Net Present Value (NPV) Method 272
The Internal Rate of Return (IRR) Method 277
Conflicting Rankings Between the NPV and IRR Methods 280
The Modified Internal Rate of Return (MIRR) Method 282
CAPITAL RATIONING 283
RISK AND CAPITAL BUDGETING 284Measuring Risk in Capital Budgeting 284
CONTENTS xiii
Finance at Work: Jim Bruner, Former Maricopa County Supervisor,State of Arizona 286
Adjusting for Risk 287
WHAT'S NEXT 288
Summary 288 • Equations Introduced in This Chapter 290 *Self-Test 290 • FinCoach Practice Exercises 291 •Review Questions 291 • Build Your Communication Skills 291 •Problems 292 • Answers to Self-Test 299
APPENDIX 10A: WRINKLES IN CAPITAL BUDGETING 302
NONSIMPLE PROJECTS 302
MULTIPLE IRRs 302
MUTUALLY EXCLUSIVE PROJECTS WITH UNEQUAL PROJECT LIVES 304
Comparing Projects with Unequal Lives 305
Equations Introduced in This Appendix 307
11 Estimating Incremental Cash Flows 308INCREMENTAL CASH FLOWS 310
TYPES OF INCREMENTAL CASH FLOWS 311
Initial Investment Cash Flows 311
Operating Cash Flows 312
Shutdown Cash Flows 314
Financing Cash Flows 315
Incremental Cash Flows of an Expansion Project 316
Financial Management and YOU: The Incremental Costs of Studying Abroad 320
Asset Replacement Decisions 321
REAL OPTIONS 322
WHAT'S NEXT 325
Summary 325 • Self-Test 326 • FinCoach Practice Exercises 327 •Review Questions 327 • Build Your Communication Skills 327 •Problems 328* Answers to Self-Test J32
12 Business Valuation 334THE IMPORTANCE OF BUSINESS VALUATION 336
A General Valuation Model 336
Applying the General Valuation Model to Businesses 337
Valuing Current Liabilities and Long-Term Debt 338
BOND VALUATION 339Semiannual Coupon Interest Payments 341
The Yield to Maturity of a Bond 342
The Relationship Between Bond YTM and Price 344
PREFERRED STOCK VALUATION 345
Finding the Present Value of Preferred Stock Dividends 346
The Yield on Preferred Stock 346
COMMON STOCK VALUATION 347
Valuing Individual Shares of Common Stock 348
Valuing Total Common Stockholders' Equity 351
The Free Cash Flow DCF Model 352
The Yield on Common Stock 359
XIV CONTENTS
VALUING COMPLETE BUSINESSES 359
The Free Cash Flow DCF Model Applied to a Complete Business 359
The Replacement Value of Assets Method 360
WHAT'S NEXT 361
Summary 361 • Equations Introduced in This Chapter 362 •Self-Test 364 • FinCoach Practice Exercises 365 •Review Questions 365 • Build Your Communication Skills 365Problems 366 • Answers to Self-Test 371
Part IV LONG-TERM FINANCING DECISIONS 374
13 Capital Structure Basics 376CAPITAL STRUCTURE 378
Operating Leverage 378
Financial Leverage 382
Combined Leverage 384
BREAKEVEN ANALYSIS AND LEVERAGE 385Constructing a Sales Breakeven Chart 386
Applying Breakeven Analysis 389
LBOs 392
Ethical Connections: Let's Rip off the Bondholders? 393
CAPITAL STRUCTURE THEORY 393Tax Deductibility of Interest 393
Modigliani and Miller 394
Toward an Optimal Capital Structure 394
WHAT'S NEXT 396
Summary 396 • Equations Introduced in This Chapter 397 •Self-Test 399 • Review Questions 400 • Build Your CommunicationSkills 400 • Problems 400 • Answers to Self-Test 405
14 Corporate Bonds, Preferred Stock, and Leasing 406BOND BASICS 408
FEATURES OF BOND INDENTURES 409
Security 410
Plans for Paying Off the Bond Issue 410
Call Provisions 410
A SAMPLE BOND REFUNDING PROBLEM 411
Restrictive Covenants 413
The Independent Trustee of the Bond Issue 414
TYPES OF BONDS 415
Secured Bonds 415
Unsecured Bonds (Debentures) 415
Convertible Bonds 416
Variable-Rate Bonds 418
Putable Bonds 419
Junk Bonds 419
International Bonds 419 ^ _ ^ _
CONTENTS XV
Ethical Connections: SEC Charges 50 Municipalities in Bid to Stop Fraud in Muni-
Bond Market 420
Super Long-Term Bonds 420
PREFERRED STOCK 420
Preferred Stock Dividends 421
Preferred Stock Investors 421
Convertible Preferred Stock 421
LEASING 422
Genuine Leases versus Fakes 422
Operating and Financial (Capital) Leases 423
Finance at Work: Hybrid Financing—Mezzanine Capital 424
Lease or Buy? 425
WHAT'S NEXT 427
Summary 428 * Equations Introduced in This Chapter 429 •Self-Test 429 • Review Questions 429 • Build Your CommunicationSkills 429 • Problems 429 • Answers to Self-Test 433
15 Common Stock 434THE CHARACTERISTICS OF COMMON STOCK 436
Stock Issued by Private Corporations 438
Stock Issued by Publicly Traded Corporations 438
Finance at Work: Chris Heller, Corporate Communications Consultant 439
Institutional Ownership of Common Stock 440
VOTING RIGHTS OF COMMON STOCKHOLDERS 440Proxies 440
Board of Directors Elections 441
THE PROS AND CONS OF EQUITY FINANCING 443
Disadvantages of Equity Financing 443
Advantages of Equity Financing 444
ISSUING COMMON STOCK 444
The Function of Investment Bankers 445
Pricing New Issues of Stock 447
RIGHTS AND WARRANTS 448
Preemptive Rights 448
Warrants 450
WHAT'S NEXT 453
Summary 453 • Equations Introduced in This Chapter 454 •Self-Test 455 • Review Questions 455 • Build Your CommunicationSkills 455* Problems 456* Answers to Self-Test 458
16 Dividend Policy 460DIVIDENDS 462
WHY A DIVIDEND POLICY IS NECESSARY 462
FACTORS AFFECTING DIVIDEND POLICY 483
Need for Funds 463
Management Expectations and Dividend Policy 463
Stockholders' Preferences 463
Restrictions on Dividend Payments 463
XVI CONTENTS
CASH VERSUS EARNINGS 465
LEADING DIVIDEND THEORIES 465The Residual Theory of Dividends 466The Clientele Dividend Theory 4 6 6
The Signaling Dividend Theory 467
The Bird-in-the-Hand Theory 467
Modigliani and Miller's Dividend Theory 468
THE MECHANICS OF PAYING DIVIDENDS 468Dividend Reinvestment Plans 4 6 9
ALTERNATIVES TO CASH DIVIDENDS 470Stock Dividends and Stock Splits 470
Financial Management and YOU: Dividend Reinvestment Records Can Avoid TaxHeadaches 470
WHAT'S NEXT 475Summary 475 • Equations Introduced in This Chapter 476 •
Self-Test 476 • Review Questions 477 • Build Your CommunicationSkills 477 • Problems 477 • Answers to Self-Test 481
Part V SHORT-TERM FINANCING DECISIONS 482
17 Working Capital Policy 484MANAGING WORKING CAPITAL 486
WHY BUSINESSES ACCUMULATE WORKING CAPITAL 486Fluctuating Current Assets 487
Permanent and Temporary Current Assets 487
LIQUIDITY VERSUS PROFITABILITY 489
ESTABLISHING THE OPTIMAL LEVEL OF CURRENT ASSETS 489
MANAGING CURRENT LIABILITIES: RISK AND RETURN 490
THREE WORKING CAPITAL FINANCING APPROACHES 490The Aggressive Approach 491The Conservative Approach 492The Moderate Approach 493
WORKING CAPITAL FINANCING AND FINANCIAL RATIOS 4 9 4
Finance at Work: Interview with Michael Coleman, Vice President ofTek Soft 495
WHAT'S NEXT 4 9 5
Summary 496 • Self-Test 496 • Review Questions 497 • Build YourCommunication Skills 497 • Problems 497 • Answers to Self-Test 502
18 Managing Cash 504CASH MANAGEMENT CONCEPTS 506
DETERMINING THE OPTIMAL CASH BALANCE 506The Minimum Cash Balance 506The Maximum Cash Balance 508Determining the Optimal Cash Balance 509
Finance at Work: Karen Noble, Professional Golfer 511
FORECASTING CASH NEEDS 512
Developing a Cash Budget 512 ^ _ _ _ ^CONTENTS xvii
MANAGING THE CASH FLOWING IN AND OUT OF THE FIRM 517
Increasing Cash Inflows 517
Decreasing Cash Outflows 521
Speeding Up Cash Inflows 521
Slowing Down Cash Outflows 522
WHAT'S NEXT 523Summary 523 • Equations Introduced in This Chapter 524 •
Self-Test 524 • Review Questions 524 • Build Your CommunicationSkills 525 • Problems 525 • Answers to Self-Test 529
19 Accounts Receivable and Inventory 530WHY FIRMS ACCUMULATE ACCOUNTS RECEIVABLE AND INVENTORY 533
HOW ACCOUNTS RECEIVABLE AND INVENTORY AFFECT PROFITABILITY
AND LIQUIDITY 533
FINDING OPTIMAL LEVELS OF ACCOUNTS RECEIVABLE AND INVENTORY 535
The Optimal Level of Accounts Receivable 535
The Optimal Level of Inventory 540
INVENTORY MANAGEMENT APPROACHES 546
The ABC Inventory Classification System 546
Just-in-Time Inventory Control (JIT) 547
MAKING CREDIT DECISIONS 547
COLLECTION POLICIES TO HANDLE BAD DEBTS 548
Finance at Work: Automating Collections 550
WHAT'S NEXT 551
Summary 552 • Equations Introduced in This Chapter 553 •Self-Test 553 • Review Questions 554 • Build Your CommunicationSkills 554 • Problems 554 • Answers to Self-Test 560
20 Short-Term Financing 564THE NEED FOR SHORT-TERM FINANCING 566
SHORT-TERM FINANCING VERSUS LONG-TERM FINANCING 566
SHORT-TERM FINANCING ALTERNATIVES 568
Short-Term Loans from Banks and Other Institutions 568
Trade Credit 568
Commercial Paper 570
HOW LOAN TERMS AFFECT THE EFFECTIVE INTEREST RATE OF A LOAN 572
The Effective Interest Rate 572
Discount Loans 573
Compensating Balances 573
Loan Maturities Shorter Than One Year 575
A Comprehensive Example 577
Computing the Amount to Borrow 577
COLLATERAL FOR SHORT-TERM LOANS 578
Accounts Receivable as Collateral 578
Inventory as Collateral 579
Financial Management and You: APR, APYand EAR 580
XVIII CONTENTS
WHAT'S NEXT 581
Summary 581 • Equations Introduced in This Chapter 582 • ""Self-Test 583 • Review Questions 583 • Build Your CommunicationSkills 583 • Problems 584 • Answers to Self-Test 586
n FINANCE IN THE GLOBAL ECONOMY 588
21 International Finance 590MULTINATIONAL CORPORATIONS 592
Financial Advantages of Foreign Operations 592
Ethical Issues Facing Multinational Corporations 593
Comparative Advantage 594
EXCHANGE RATES AND THEIR EFFECTS 594
Fluctuating Exchange Rates 595
Cross Rates 596
Exchange Rate Effects on MNCS 598
•• Exchange Rate Effects on Foreign Stock and Bond Investments 598
MANAGING RISK 599
Hedging 599Diversification Benefits of Foreign Investments 599
American Depository Receipts 600Finance at Work: Interview with Don Burton, International Import-Export
Institute 601
EXCHANGE RATE THEORIES 601
Purchasing Power Parity Theory 602
International Fisher Effect 602
Interest Rate Parity Theory 602
Other Factors Affecting Exchange Rates 603
Government Intervention in Foreign Exchange Markets 604
POLITICAL AND CULTURAL RISKS FACING MNCs 604Political Risk 604
Cultural Risk 605
INTERNATIONAL TRADE AGREEMENTS 606
NAFTA 606
GATT 606
European Union 607
Free Trade versus Fair Trade 607
Summary 608 • Equations Introduced in This Chapter 609 •Self-Test 609 • Review Questions 609 • Build Your CommunicationSkills 610 • Problems 610 • Answers to Self-Test 612
Appendix A-1
Glossary G-1
Index 1-1
CONTENTS XIX
