CourseSmart Reader

Foundations of Financial Management, 12th Edition

by Block, Stanley; Hirt, Geoffrey

Publisher: McGraw-Hill Higher Education

Publishing Date: 2006/10/02

eText ISBN-10

0-07-722215-6

eText ISBN-13

978-0-07-722215-4

Print ISBN-10

0-07-302720-0

Print ISBN-13

978-0-07-302720-3

Saleable Print ISBN-10

0-07-329581-7

Saleable Print ISBN-13

978-0-07-329581-7

Table of Contents

Part 1. INTRODUCTION, 2

1. The Goals and Functions of Financial Management, 4

The Field of Finance, 5

Evolution of the Field of Finance, 5

Recent Issues in Finance, 6

The Impact of the Internet, 6

Functions of Financial Management, 7

Forms of Organization, 8

Corporate Governance, 10

Sarbanes-Oxley Act, 11

Goals of Financial Management, 11

A Valuation Approach, 12

Maximizing Shareholder Wealth, 12

Management and Stockholder Wealth, 13

Social Responsibility and Ethical Behavior, 13

The Role of the Financial Markets, 15

Structure and Functions of the Financial Markets, 15

Allocation of Capital, 16

Institutional Pressure on Public Companies to Restructure, 17

Internationalization of the Financial Markets, 17

The Internet and Changes in the Capital Markets, 18

Format of the Text, 18

List of Terms, 20

Discussion Questions, 20

Web Exercise, 21

Part 2. FINANCIAL ANALYSIS AND PLANNING, 22

2. Review of Accounting, 24

Income Statement, 25

Return to Capital, 26

Price-Earnings Ratio Applied to Earnings per Share, 26

Limitations of the Income Statement, 27

Balance Sheet, 28

Interpretation of Balance Sheet Items, 28

Concept of Net Worth, 30

Limitations of the Balance Sheet, 30

Statement of Cash Flows, 31

Developing an Actual Statement, 32

Determining Cash Flows from Operating Activities, 32

Determining Cash Flows from Investing Activities, 34

Determining Cash Flows from Financing Activities, 34

Combining the Three Sections of the Statement, 36

Depreciation and Funds Flow, 37

Free Cash Flow, 37

Income Tax Considerations, 38

Corporate Tax Rates, 40

Cost of a Tax-Deductible Expense, 40

Depreciation as a Tax Shield, 40

List of Terms, 42

Discussion Questions, 43

Practice Problems and Solutions, 43

Web Exercise, 51

S&P Problems, 52

3. Financial Analysis, 53

Ratio Analysis, 54

Classification System, 54

The Analysis, 56

Trend Analysis, 61

Impact of Inflation on Financial Analysis, 65

An Illustration, 65

Disinflation Effect, 66

Other Elements of Distortion in Reported Income, 67

Explanation of Discrepancies, 67

List of Terms, 70

Discussion Questions, 70

Practice Problems and Solutions, 71

Comprehensive Problems, 85

Web Exercise, 90

S&P Problems, 90

4. Financial Forecasting, 92

Constructing Pro Forma Statements, 93

Pro Forma Income Statement, 93

Establish a Sales Projection, 94

Determine a Production Schedule and the Gross Profit, 94

Cost of Goods Sold, 96

Other Expense Items, 97

Actual Pro Forma Income Statement, 97

Cash Budget, 97

Cash Receipts, 98

Cash Payments, 98

Actual Budget, 100

Pro Forma Balance Sheet, 101

Explanation of Pro Forma Balance Sheet, 101

Analysis of Pro Forma Statement, 104

Percent-of-Sales Method, 104

List of Terms, 106

Discussion Questions, 107

Practice Problems and Solutions, 107

Comprehensive Problems, 116

Web Exercise, 118

5. Operating and Financial Leverage, 119

Leverage in a Business, 120

Operating Leverage, 120

Break-Even Analysis, 120

A More Conservative Approach, 122

The Risk Factor, 123

Cash Break-Even Analysis, 124

Degree of Operating Leverage, 124

Limitations of Analysis, 126

Financial Leverage, 127

Impact on Earnings, 128

Degree of Financial Leverage, 128

Limitations to Use of Financial Leverage, 131

Combining Operating and Financial Leverage, 131

Degree of Combined Leverage, 133

A Word of Caution, 135

Review of Formulas, 135

List of Terms, 136

Discussion Questions, 136

Practice Problems and Solutions, 137

Comprehensive Problem, 147

Web Exercise, 148

S&P Problems, 149

Part 3. WORKING CAPITAL MANAGEMENT, 150

6. Working Capital and the Financing Decision, 152

The Nature of Asset Growth, 154

Controlling Assets—Matching Sales and Production, 154

Temporary Assets under Level Production—An Example, 158

Patterns of Financing, 163

Alternative Plans, 164

Long-Term Financing, 164

Short-Term Financing (Opposite Approach), 165

The Financing Decision, 165

Term Structure of Interest Rates, 167

A Decision Process, 170

Introducing Varying Conditions, 171

Expected Value, 171

Shifts in Asset Structure, 172

Toward an Optimal Policy, 173

List of Terms, 175

Discussion Questions, 175

Practice Problems and Solutions, 176

Web Exercise, 183

S&P Problems, 183

7. Current Asset Management, 185

Cash Management, 186

Reasons for Holding Cash Balances, 186

Cash Flow Cycle, 186

Collections and Disbursements, 189

Improving Collections, 191

Extending Disbursements, 192

Cost-Benefit Analysis, 192

Electronic Funds Transfer, 193

International Cash Management, 196

Marketable Securities, 196

Management of Accounts Receivable, 201

Accounts Receivable as an Investment, 201

Credit Policy Administration, 201

An Actual Credit Decision, 206

Inventory Management, 207

Level versus Seasonal Production, 207

Inventory Policy in Inflation (and Deflation), 208

The Inventory Decision Model, 208

Economic Ordering Quantity, 209

Safety Stock and Stock Outs, 211

Just-in-Time Inventory Management, 211

List of Terms, 214

Discussion Questions, 215

Practice Problems and Solutions, 215

Comprehensive Problem, 221

Web Exercise, 222

8. Sources of Short-Term Financing, 223

Trade Credit, 224

Payment Period, 224

Cash Discount Policy, 224

Net Credit Position, 225

Bank Credit, 225

Prime Rate and LIBOR, 226

Compensating Balances, 227

Maturity Provisions, 228

Cost of Commercial Bank Financing, 229

Interest Costs with Compensating Balances, 229

Rate on Installment Loans, 230

Annual Percentage Rate, 230

The Credit Crunch Phenomenon, 231

Financing through Commercial Paper, 231

Advantages of Commercial Paper, 233

Limitations on the Issuance of Commercial Paper, 234

Foreign Borrowing, 234

Use of Collateral in Short-Term Financing, 235

Accounts Receivable Financing, 235

Pledging Accounts Receivable, 235

Factoring Receivables, 236

Asset-Backed Public Offerings, 236

Inventory Financing, 238

Stages of Production, 239

Nature of Lender Control, 239

Appraisal of Inventory Control Devices, 239

Hedging to Reduce Borrowing Risk, 240

List of Terms, 242

Discussion Questions, 242

Practice Problems and Solutions, 243

Web Exercise, 248

Part 4. THE CAPITAL BUDGETING PROCESS, 250

9. The Time Value of Money, 253

Relationship to the Capital Outlay Decision, 254

Future Value—Single Amount, 254

Present Value—Single Amount, 255

Future Value—Annuity, 256

Present Value—Annuity, 258

Graphical Presentation of Time Value Relationships, 260

The Relationship between Present Value and Future Value, 260

The Relationship between the Present Value of a Single Amount and the Present Value of an Annuity, 263

Future Value Related to the Future Value of an Annuity, 265

Determining the Annuity Value, 266

Annuity Equaling a Future Value, 266

Annuity Equaling a Present Value, 266

Determining the Yield on an Investment, 268

Yield—Present Value of a Single Amount, 268

Yield—Present Value of an Annuity, 269

Special Considerations in Time Value Analysis, 270

Patterns of Payment, 270

Special Review of the Chapter, 272

List of Terms, 274

Discussion Questions, 274

Practice Problems and Solutions, 275

Comprehensive Problem, 281

10. Valuation and Rates of Return, 282

Valuation Concepts, 283

Valuation of Bonds, 283

Concept of Yield to Maturity, 285

Changing the Yield to Maturity and the Impact on Bond Valuation, 286

Time to Maturity, 289

Determining Yield to Maturity from the Bond Price, 289

Semiannual Interest and Bond Prices, 292

Valuation and Preferred Stock, 293

Determining the Required Rate of Return (Yield) from the Market Price, 294

Valuation of Common Stock, 295

No Growth in Dividends, 295

Constant Growth in Dividends, 296

Determining the Required Rate of Return from the Market Price, 298

The Price-Earnings Ratio Concept and Valuation, 299

Variable Growth in Dividends, 300

Summary and Review of Formulas, 302

Preferred Stock, 303

Common Stock, 304

List of Terms, 304

Discussion Questions, 304

Practice Problems and Solutions, 305

Comprehensive Problem, 312

Web Exercise, 313

Appendix 10A The Bond Yield to Maturity Using Interpolation, 314

Appendix 10B Using Calculators for Financial Analysis, 315

Appendix 10C Valuation of a Supernormal Growth Firm, 324

11. Cost of Capital, 327

The Overall Concept, 328

Cost of Debt, 328

Costs of Preferred Stock, 331

Cost of Common Equity, 331

Valuation Approach, 332

Required Return on Common Stock Using the Capital Asset Pricing Model, 332

Cost of Retained Earnings, 333

Cost of New Common Stock, 335

Overview of Common Stock Costs, 335

Optimal Capital Structure—Weighting Costs, 336

Capital Acquisition and Investment Decision Making, 338

Cost of Capital in the Capital Budgeting Decision, 338

The Marginal Cost of Capital, 340

Review of Formulas, 345

List of Terms, 346

Discussion Questions, 346

Practice Problems and Solutions, 347

Comprehensive Problems, 356

Web Exercise, 358

S&P Problems, 358

Appendix 11A Cost of Capital and the Capital Asset Pricing Model (Optional), 359

12. The Capital Budgeting Decision, 367

Administrative Considerations, 368

Accounting Flows versus Cash Flows, 368

Methods of Ranking Investment Proposals, 371

Payback Method, 371

Internal Rate of Return, 372

Net Present Value, 374

Selection Strategy, 375

Reinvestment Assumption, 376

Capital Rationing, 378

Net Present Value Profile, 379

Characteristics of Investment C, 380

Combining Cash Flow Analysis and Selection Strategy, 382

The Rules of Depreciation, 382

The Tax Rate, 384

Actual Investment Decision, 384

The Replacement Decision, 385

Sale of Old Asset, 386

Incremental Depreciation, 387

Cost Savings, 388

Elective Expensing, 390

List of Terms, 390

Discussion Questions, 390

Practice Problems and Solutions, 391

Comprehensive Problem, 400

Web Exercise, 401

S&P Problems, 401

13. Risk and Capital Budgeting, 403

Definition of Risk in Capital Budgeting, 404

The Concept of Risk-Averse, 405

Actual Measurement of Risk, 405

Risk and the Capital Budgeting Process, 408

Risk-Adjusted Discount Rate, 409

Increasing Risk over Time, 410

Qualitative Measures, 411

Simulation Models, 412

Decision Trees, 413

The Portfolio Effect, 415

Portfolio Risk, 415

Evaluation of Combinations, 418

The Share Price Effect, 419

Review of Formulas, 419

List of Terms, 420

Discussion Questions, 420

Practice Problems and Solutions, 420

Comprehensive Problems, 431

Web Exercise, 433

Part 5. LONG-TERM FINANCING, 434

14. Capital Markets, 436

International Capital Markets, 437

Competition for Funds in the U.S. Capital Markets, 439

Government Securities, 439

Corporate Securities, 440

The Supply of Capital Funds, 442

The Role of the Security Markets, 444

The Organization of the Security Markets, 445

The New York Stock Exchange, 445

The NASDAQ Market, 448

The American Stock Exchange, 448

Regional Stock Exchanges, 448

Foreign Exchanges, 449

Electronic Communication Networks (ECNs), 449

National Association of Securities Dealers (NASD), 450

Market Efficiency, 450

The Efficient Market Hypothesis, 450

Regulation of the Security Markets, 451

Securities Act of 1933, 451

Securities Exchange Act of 1934, 452

Securities Acts Amendments of 1975, 452

Sarbanes-Oxley Act of 2002, 453

List of Terms, 454

Discussion Questions, 455

Web Exercise, 455

S&P Problems, 456

15. Investment Banking: Public and Private Placement, 457

The Role of Investment Banking, 458

Enumeration of Functions, 461

The Distribution Process, 462

Pricing the Security, 465

Market Stabilization, 465

Aftermarket, 466

Shelf Registration, 466

Public versus Private Financing, 467

Advantages of Being Public, 467

Disadvantages of Being Public, 468

Public Offerings, 468

A Classic Example of Instant Wealth—EDS Goes Public, 468

Internet Capital Group—A Second Example, 469

Private Placement, 473

Going Private and Leveraged Buyouts, 473

International Investment Banking Deals, 474

Privatization, 474

List of Terms, 477

Discussion Questions, 477

Practice Problems and Solutions, 478

Comprehensive Problem, 484

Web Exercise, 486

S&P Problems, 486

16. Long-Term Debt and Lease Financing, 488

The Expanding Role of Debt, 489

The Debt Contract, 489

Security Provisions, 490

Methods of Repayment, 491

An Example: Dillard's 7.875 Percent Bond, 492

Bond Prices, Yields, and Ratings, 492

Bond Yields, 495

Bond Ratings, 496

Examining Actual Bond Ratings, 497

The Refunding Decision, 498

A Capital Budgeting Problem, 498

Step A—Outflow Considerations, 499

Step B—Inflow Considerations, 500

Step C—Net Present Value, 501

Other Forms of Bond Financing, 502

Advantages and Disadvantages of Debt, 503

Benefits of Debt, 504

Drawbacks of Debt, 504

Eurobond Market, 504

Leasing as a Form of Debt, 505

Capital Lease versus Operating Lease, 506

Income Statement Effect, 507

Advantages of Leasing, 507

List of Terms, 508

Discussion Questions, 508

Practice Problems and Solutions, 509

Comprehensive Problem, 516

Web Exercise, 517

S&P Problems, 517

Appendix 16A Financial Alternatives for Distressed Firms, 518

Out-of-Court Settlement, 518

In-Court Settlements—Formal Bankruptcy, 519

List of Terms, 522

Discussion Questions, 523

Appendix 16B Lease versus Purchase Decision, 524

17. Common and Preferred Stock Financing, 527

Common Stockholders' Claim to Income, 528

The Voting Right, 529

Cumulative Voting, 530

The Right to Purchase New Shares, 532

The Use of Rights in Financing, 533

Effect of Rights on Stockholder's Position, 535

Desirable Features of Rights Offerings, 536

Poison Pills, 536

American Depository Receipts, 537

Preferred Stock Financing, 538

Justification for Preferred Stock, 539

Provisions Associated with Preferred Stock, 540

Comparing Features of Common and Preferred Stock and Debt, 542

Review of Formulas, 544

List of Terms, 544

Discussion Questions, 545

Practice Problems and Solutions, 546

Comprehensive Problems, 551

Web Exercise, 553

18. Dividend Policy and Retained Earnings, 554

The Marginal Principle of Retained Earnings, 555

Life Cycle Growth and Dividends, 555

Dividends as a Passive Variable, 556

An Incomplete Theory, 556

Arguments for the Relevance of Dividends, 557

Dividend Stability, 558

Other Factors Influencing Dividend Policy, 558

Legal Rules, 558

Cash Position of the Firm, 560

Access to Capital Markets, 560

Desire for Control, 561

Tax Position of Shareholders, 561

Dividend Payment Procedures, 561

Stock Dividend, 563

Accounting Considerations for a Stock Dividend, 563

Value to the Investor, 563

Possible Value of Stock Dividends, 564

Use of Stock Dividends, 565

Stock Splits, 565

Reverse Stock Splits, 566

Repurchase of Stock as an Alternative to Dividends, 566

Other Reasons for Repurchase, 568

Dividend Reinvestment Plans, 568

List of Terms, 569

Discussion Questions, 569

Practice Problems and Solutions, 570

Comprehensive Problem, 578

Web Exercise, 578

S&P Problems, 579

19. Convertibles, Warrants, and Derivatives, 580

Convertible Securities, 581

Value of the Convertible Bond, 581

Is This Fool's Gold?, 584

Advantages and Disadvantages to the Corporation, 584

Forcing Conversion, 586

Accounting Considerations with Convertibles, 587

Financing through Warrants, 589

Valuation of Warrants, 590

Use of Warrants in Corporate Finance, 592

Accounting Considerations with Warrants, 592

Derivative Securities, 593

Review of Formulas, 595

List of Terms, 596

Discussion Questions, 596

Practice Problems and Solutions, 597

Comprehensive Problems, 602

Web Exercise, 603

Part 6. EXPANDING THE PERSPECTIVE OF CORPORATE FINANCE, 604

20. External Growth through Mergers, 606

Motives for Business Combinations, 607

Financial Motives, 608

Nonfinancial Motives, 609

Motives of Selling Stockholders, 609

Terms of Exchange, 611

Cash Purchases, 611

Stock-for-Stock Exchange, 612

Portfolio Effect, 613

Accounting Considerations in Mergers and Acquisitions, 614

Negotiated versus Tendered Offers, 615

Premium Offers and Stock Price Movements, 617

Two-Step Buyout, 618

List of Terms, 619

Discussion Questions, 619

Practice Problems and Solutions, 620

Web Exercise, 625

S&P Problems, 626

21. International Financial Management, 627

The Multinational Corporation: Nature and Environment, 630

Foreign Exchange Rates, 631

Factors Influencing Exchange Rates, 632

Spot Rates and Forward Rates, 634

Cross Rates, 636

Managing Foreign Exchange Risk, 636

Foreign Investment Decisions, 639

Analysis of Political Risk, 641

Financing International Business Operations, 643

Funding of Transactions, 643

Some Unsettled Issues in International Finance, 649

List of Terms, 650

Discussion Questions, 651

Practice Problems and Solutions, 651

Web Exercise, 654

S&P Problems, 654

Appendix 21A Cash Flow Analysis and the Foreign Investment Decision, 655

Appendixes, A-1

Appendix A. Future Value of $1, FV_IF, A-2

Appendix B. Present Value of $1, PV_IF, A-4

Appendix C. Future Value of an Annuity of $1, FV _IFA, A-6

Appendix D. Present Value of an Annuity of $1, PV _IFA, A-8

Selected References, R-1

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