You are on page 1of 9

Foundations of Financial Management

THIRTEENTH EDITION

STANLEY B. BLOCK
Texas Christian University

GEOFFREY A. HIRT
DePaul University

BARTLEY R. DANIELSEN
North Carolina State University

McGraw-Hill Irwln
Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis : Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei ' Toronto

Contents
PART1 ! INTRODUCTION 1 The Goals and Functions of Financial Management 4
The Field of Finance 5 Evolution of the Field of Finance 5 Modern Issues in Finance 6 The Impact of the Internet 6 Functions of Financial Management 7 Forms of Organization 8 Sole Proprietorship 8 Partnership 8 Corporation 9 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 75 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 19 Parts 19 1. Introduction 19 2. Financial Analysis and Planning 19 3. Working Capital Management 19 4. The Capital Budgeting Process 20 5. hong-Term Financing 20 6. Expanding the Perspective of Corporate Finance 20 List of Terms 20 Discussion Questions 21 Web Exercise 21

1 FINANCIAL ANALYSIS AND PLANNING 2 Review of Accounting 26


Income Statement 27 Return to Capital 28 Price-Earnings Ratio Applied to Earnings per Share 28 Limitations of the Income Statement 29 Balance Sheet 30 Interpretation of Balance Sheet Items 30 Concept of Net Worth 32 Limitations of the Balance Sheet 32 Statement of Cash Flows 33 Developing an Actual Statement 34 Determining Cash Flows from Operating Activities 34 Determining Cash Flows from Investing Activities 36 Determining Cash Flows from Financing Activities 36 Combining the Three Sections of the Statement 38 Depreciation and Funds Flow 39 Free Cash Flow 39 Income Tax Considerations 40 Corporate Tax Rates 41 Cost of a Tax-Deductible Expense 42 Depreciation as a Tax Shield 42 Summary 43 List of Terms 44 Discussion Questions 44 Practice Problems and Solutions 44 Problems 45 Web Exercise 53 S&P Problems 53

3 Financial Analysis 55
Ratio Analysis 56 Classification System 57 The Analysis 58 A. Profitability Ratios 58 B. Asset Utilization Ratios 61 C. Liquidity Ratios 62D. Debt Utilization Ratios 62
XIX

XX

Contents Trend Analysis 63 Impact of Inflation on Financial Analysis 67 An Illustration 67 Disinflation Effect 68 Deflation 69 Other Elements of Distortion in Reported Income 69 Explanation of Discrepancies 69 Sales 70 Cost of Goods Sold 70 Extraordinary Gains/Losses 70 Net Income 71 Summary 72 List of Terms 72 Discussion Questions 72 Practice Problems and Solutions 73 Problems 76 Comprehensive Problems 87 Web Exercise 92 S&P Problems 92

5 Operating and Financial Leverage 122


Leverage in a Business 123 Operating Leverage 123 Break-Even Analysis 123 A More Conservative Approach 725 The Risk Factor 727 Cash Break-Even Analysis 727 Degree of Operating Leverage 72S Leveraged Firm 128 Conservative Firm 129 Limitations of Analysis 729 Financial Leverage 130 Impact on Earnings 131 Degree of Financial Leverage 737 Plan A (Leveraged) 133 Plan B (Conservative) 134 Limitations to Use of Financial Leverage 134 Combining Operating and Financial Leverage 134 Degree of Combined Leverage 756" A Word of Caution 138 Summary 138 Review of Formulas 138 List of Terms 139 Discussion Questions 139 Practice Problems and Solutions 140 Problems 141 Comprehensive Problem 149 Web Exercise 151 S&P Problems 151

4 Financial Forecasting 94
Constructing Pro Forma Statements 95 Pro Forma Income Statement 95 Establish a Sales Projection 96 Determine a Production Schedule and the Gross Profit 96 Cost of Goods Sold 98 Other Expense Items 99 Actual Pro Forma Income Statement 99 Cash Budget 100 Cash Receipts 100 Cash Payments 101 Actual Budget 102 Pro Forma Balance Sheet 103 Explanation of Pro Forma Balance Sheet 105 Analysis of Pro Forma Statement 106 Percent-of-Sales Method 706 Summary 108 List of Terms 109 Discussion Questions 109 Practice Problems and Solutions 109 Problems 111 Comprehensive Problems 118 Web Exercise 121

PART 3 ! WORKING CAPITAL MANAGEMENT 6 Working Capital and the Financing Decision 156
The Nature of Asset Growth 158 Controlling AssetsMatching Sales and Production 755 Temporary Assets under Level ProductionAn Example 762 Patterns of Financing 767 Alternative Plans 168 Long-Term Financing 765 Short-Term Financing (Opposite Approach) 769 The Financing Decision 769 Term Structure of Interest Rates 7 77

Contents A Decision Process 774 Introducing Varying Conditions 175 Expected Value 775 Shifts in Asset Structure 7 76 Toward an Optimal Policy 777 Summary 179 List of Terms 179 Discussion Questions 180 Practice Problems and Solutions 180 Problems 181 Web Exercise 187 S&P Problems 187 Discussion Questions 216 Practice Problems and Solutions Problems 217 Comprehensive Problem 222 Web Exercise 223

XXI

216

8 Sources of Short-Term Financing 224


Trade Credit 225 Payment Period 225 Cash Discount Policy 225 Net Credit Position 226 Bank Credit 226 Prime Rate and LIBOR 22 7 Compensating Balances 228 Maturity Provisions 229 Cost of Commercial Bank Financing 230 Interest Costs with Compensating Balances 230 Rate on Installment Loans 231 Annual Percentage Rate 231 The Credit Crunch Phenomenon 232 Financing through Commercial Paper 233 Advantages of Commercial Paper 234 Limitations on the Issuance of Commercial Paper 235 Foreign Borrowing 236 Use of Collateral in Short-Term Financing 236 Accounts Receivable Financing 237 Pledging Accounts Receivable 237 Factoring Receivables 237 Asset-Backed Public Offerings 238 Inventory Financing 239 Stages of Production 240 Nature of Lender Control 240 Blanket Inventory Liens 240 Trust Receipts 240 Warehousing 240 Appraisal of Inventory Control Devices 240 Hedging to Reduce Borrowing Risk 247 Summary 243 List of Terms 244 Discussion Questions 244 Practice Problems and Solutions 245 Problems 246 Comprehensive Problem 250 Web Exercise 251

7 Current Asset Management 189


Cash Management 190 Reasons for Holding Cash Balances 790 Cash Flow Cycle 790 Collections and Disbursements 193 Float 794 Improving Collections 794 Extending Disbursements 794 Cost-Benefit Analysis 795 Electronic Funds Transfer 795 International Cash Management 797 Marketable Securities 798 Management of Accounts Receivable 202 Accounts Receivable as an Investment 202 Credit Policy Administration 202 Credit Standards 202 Terms of Trade 204 Collection Policy 206 An Actual Credit Decision 207 Inventory Management 208 Level versus Seasonal Production 208 Inventory Policy in Inflation (and Deflation) 209 The Inventory Decision Model 209 Carrying Costs 209 Ordering Costs 209 Economic Ordering Quantity 270 Safety Stock and Stockouts 277 Just-in-Time Inventory Management 272 Cost Savings from Lower Inventory 212 Other Benefits 213 The Downside of JIT 213 Summary 214 List of Terms 215

XX11

Contents A 13 Percent Discount Rate 293 A 12 Percent Discount Rate 294 Formula for Bond Yield 294 Semiannual Interest and Bond Prices 295 Valuation and Preferred Stock 296 Determining the Required Rate of Return (Yield) from the Market Price 298 Valuation of Common Stock 298 No Growth in Dividends 299 Constant Growth in Dividends 299 Stock Valuation Based on Future Stock Value 301 Determining the Required Rate of Return from the Market Price 507 The Price-Earnings Ratio Concept and Valuation 302 Variable Growth in Dividends 305 Summary and Review of Formulas 306 Bonds 306 Preferred Stock 307 Common Stock 307 List of Terms 308 Discussion Questions 308 Practice Problems and Solutions 309 Problems 310 Comprehensive Problem 316 Web Exercise 317 Appendix 10A The Bond Yield to Maturity Using Interpolation 318 Appendix 10B Using Calculators for Financial Analysis 319 Appendix IOC Valuation of a Supernormal Growth Firm 328

PART 4 I THE CAPITAL BUDGETING PROCESS 9 The Time Value of Money 255
Relationship to the Capital Outlay Decision 256 Future ValueSingle Amount 256 Present ValueSingle Amount 257 Future ValueAnnuity 258 Present ValueAnnuity 260 Graphical Presentation of Time Value Relationships 262 The Relationship between Present Value and Future Value 262 The Relationship between the Present Value of a Single Amount and the Present Value of an Annuity 265 Future Value Related to the Future Value of an Annuity 267 Determining the Annuity Value 268 Annuity Equaling a Future Value 268 Annuity Equaling a Present Value 268 Determining the Yield on an Investment 270 YieldPresent Value of a Single Amount 270 YieldPresent Value of an Annuity ' 277 Special Considerations in Time Value Analysis 272 Patterns of Payment 272 Special Review of the Chapter 274 List of Terms 276 Discussion Questions 276 Practice Problems and Solutions 277 Problems 278 Comprehensive Problem 284

10 Valuation and Rates of Return 285


Valuation Concepts 286 Valuation of Bonds 286 Present Value of Interest Payments 287 Present Value of Principal Payment (Par Value) at Maturity 287 Concept of Yield to Maturity 288 Changing the Yield to Maturity and the Impact on Bond Valuation 290 Increase in Inflation Premium 290 Decrease in Inflation Premium 290 Time to Maturity 292 Determining Yield to Maturity from the Bond Price 292

11 Cost of Capital 331


The Overall Concept 332 Cost of Debt 332 Costs of Preferred Stock 335 Cost of Common Equity 335 Valuation Approach 336 Required Return on Common Stock Using the Capital Asset Pricing Model 336 Cost of Retained Earnings 337 Cost of New Common Stock 339 Overview of Common Stock Costs 339 Optimal Capital StructureWeighting Costs 340

Contents Capital Acquisition and Investment Decision Making 342 Cost of Capital in the Capital Budgeting Decision 342 The Marginal Cost of Capital 344 Summary 349 Review of Formulas 350 List of Terms 350 Discussion Questions 351 Practice Problems and Solutions 351 Problems 354 Comprehensive Problems 361 Web Exercise 363 S&P Problems 363 Appendix 11A Cost of Capital and the Capital Asset Pricing Model (Optional) 364

xxiii

13 Risk and Capital Budgeting 407


Definition of Risk in Capital Budgeting 408 The Concept of Risk-Averse 409 Actual Measurement of Risk 409 Risk and the Capital Budgeting Process 472 Risk-Adjusted Discount Rate 413 Increasing Risk over Time 474 Qualitative Measures 474 ExampleRisk-Adjusted Discount Rate 415 Simulation Models 476 Decision Trees 477 The Portfolio Effect 418 Portfolio Risk 479 Evaluation of Combinations 422 The Share Price Effect 423 Summary 423 Review of Formulas 423 List of Terms 424 Discussion Questions 424 Practice Problems and Solutions 424 Problems 426 Comprehensive Problems 436 Web Exercise 439

12 The Capital Budgeting Decision

371

Administrative Considerations 372 Accounting Flows versus Cash Flows 372 Methods of Ranking Investment Proposals 375 Payback Method 375 Internal Rate of Return 376 Net Present Value 378 Selection Strategy 379 Reinvestment Assumption 380 Modified Internal Rate of Return 381 Capital Rationing 382 Net Present Value Profile 383 Characteristics of Investment C 384 Combining Cash Flow Analysis and Selection Strategy 386 The Rules of Depreciation 386 The Tax Rate 388 Actual Investment Decision 388 The Replacement Decision 389 Sale of Old Asset 390 Incremental Depreciation 391 Cost Savings 392 Elective Expensing 394 Summary 394 List of Terms 394 Discussion Questions 394 Practice Problems and Solutions 395 Problems 396 Comprehensive Problem 405 Web Exercise 405 S&P Problems 406

PARTS

i LONG-TERM FINANCING 14 Capital Markets 442


International Capital Markets 443 Competition for Funds in the U.S. Capital Markets 445 Government Securities 446 U.S. Government Securities 446 Federally Sponsored Credit Agencies 446 State and Local Securities 446 Corporate Securities 446 Corporate Bonds 446 Preferred Stock 447 Common Stock 447 Internal versus External Sources ofFunds 447 The Supply of Capital Funds 448 The Role of the Security Markets 450 The Organization of the Security Markets 457 Traditional Organized Exchanges 457 Listing Requirements for Firms 452

xxiv

Contents Electronic Communication Networks (ECNs) 452 The New York Stock Exchange 453 The NASDAQ Market 453 Foreign Exchanges 454 Market Efficiency 455 The Efficient Market Hypothesis 456 Regulation of the Security Markets 456 Securities Act of 1933 456 Securities Exchange Act of 1934 457 Securities Acts Amendments of 1975 458 Sarbanes-OxleyActof2002 458 Summary 460 List of Terms 460 Discussion Questions 461 Web Exercise 461 15 Investment Banking: Public and Private Placement 462 The Role of Investment Banking 463 Concentration of Capital 463 The Gramm-Leach-Bliley Act Repeals the Glass-Steagall Act 465 Investment Banking Competitors 466 Enumeration of Functions 466 Underwriter 466 Market Maker 467 Advisor 467 Agency Functions 467 The Distribution Process 467 The Spread 468 Pricing the Security 469 Dilution 470 Market Stabilization 477 Aftermarket 477 Shelf Registration 472 Public versus Private Financing 472 Advantages of Being Public 472 Disadvantages of Being Public 473 Public Offerings 473 A Classic Example of Instant Wealth EDS Goes Public 473 Internet Capital GroupA Second Example 474 Private Placement 478 Going Private and Leveraged Buyouts 478 International Investment Banking Deals 479 Privatization 479 Summary 480 List of Terms 480 Discussion Questions 481 Practice Problems and Solutions Problems 482 Comprehensive Problem 488 Web Exercise 489 S&P Problems 489

481

16 Long-Term Debt and Lease Financing The Expanding Role of Debt 492 The Debt Contract 492 Par Value 492 Coupon Rate 493 Maturity Date 493 Security Provisions 493 Unsecured Debt 493 Methods of Repayment 494 Serial Payments 494 Sinking-Fund Provision 495 Conversion 495 Call Feature 495

491

An Example: Kerr McGee's 7.875 Percent Bond 495 Bond Prices, Yields, and Ratings 495 Bond Yields 498 Coupon Rate (Nominal Yield) 498 Current Yield 499 Yield to Maturity 499 Bond Ratings 499 Examining Actual Bond Ratings 500 The Refunding Decision 507 A Capital Budgeting Problem 507 Step AOutflow Considerations 502 Step BInflow Considerations 503 Step CNet Present Value 504 Other Forms of Bond Financing 505 Advantages and Disadvantages of Debt 506 Benefits of Debt 507 Drawbacks of Debt 507 Eurobond Market 507 Leasing as a Form of Debt 508 Capital Lease versus Operating Lease Income Statement Effect 570 Advantages of Leasing 570 Summary 511 List of Terms 511 Discussion Questions 511 Practice Problems and Solutions 512 Problems 515 Comprehensive Problem 519 Web Exercise 520 509

Contents S&P Problems 520 Appendix 16A Financial Alternatives for Distressed Firms 521 Out-of-Court Settlement 527 In-Court SettlementsFormal Bankruptcy 522 Reorganization 522 Liquidation 522 List of Terms 525 Discussion Questions 526 Problems 526 Appendix 16B Lease versus Purchase Decision 527 Problems 529

XXV

18 Dividend Policy and Retained Earnings 557


The Marginal Principle of Retained Earnings 558 Life Cycle Growth and Dividends 558 Dividends as a Passive Variable 559 An Incomplete Theory 559 Arguments for the Relevance of Dividends 560 Dividend Stability 567 Other Factors Influencing Dividend Policy 567 Legal Rules 567 Cash Position of the Firm 563 Access to Capital Markets 563 Desire for Control 564 Tax Position of Shareholders 564 Dividend Payment Procedures 564 Stock Dividend 566 Accounting Considerations for a Stock Dividend 566 Value to the Investor 566 Possible Value of Stock Dividends 567 Use of Stock Dividends 568 Stock Splits 568 Reverse Stock Splits 569 Repurchase of Stock as an Alternative to Dividends 569 Other Reasons for Repurchase 577 Dividend Reinvestment Plans 572 Summary 572 List of Terms 573 Discussion Questions 573 Practice Problems and Solutions 573 Problems 574 Comprehensive Problem 582 Web Exercise 582 S&P Problems 583

17 Common and Preferred Stock Financing 530


Common Stockholders' Claim to Income 531 The Voting Right 532 Cumulative Voting 533 The Right to Purchase New Shares 535 The Use of Rights in Financing 536 Rights Required 536 Monetary Value of a Right 536 Effect of Rights on Stockholder's Position 538 Desirable Features of Rights Offerings 540 Poison Pills 540 American Depository Receipts 547 Preferred Stock Financing 547 Justification for Preferred Stock 542 Investor Interest 542 Summary of Tax Considerations 543 Provisions Associated with Preferred Stock 543 1. Cumulative Dividends 543 2. Conversion Feature 544 3. Call Feature 544 4. Participation Provision 544 5. Floating Rate 544 6. Dutch Auction Preferred Stock 544 7. Par Value 545 Comparing Features of Common and Preferred Stock and Debt 545 Summary 546 Review of Formulas 547 List of Terms 548 Discussion Questions 548 Practice Problems and Solutions 549 Problems 550 Comprehensive Problems 554 Web Exercise 556

19 Convertibles, Warrants, and Derivatives 584


Convertible Securities 585 Value of the Convertible Bond 585 Is This Fool's Gold? 588 Advantages and Disadvantages to the Corporation 589 Forcing Conversion 590 Accounting Considerations with Convertibles 597 Financing through Warrants 593 Valuation of Warrants 594 Use of Warrants in Corporate Finance 596

XXVI

Contents Accounting Considerations with Warrants 597 Derivative Securities 598 Options 598 Futures 599 Summary 600 Review of Formulas 600 List of Terms 601 Discussion Questions 601 Practice Problems and Solutions 602 Problems 603 Comprehensive Problems 607 Web Exercise 608 Inflation 639 Interest Rates 639 Balance of Payments 639 Government Policies 640 Other Factors 640 Spot Rates and Forward Rates 640 Cross Rates 642 Managing Foreign Exchange Risk 642 Forward Exchange Market Hedge 644 Money Market Hedge 644 Currency Futures Market Hedge 645 Foreign Investment Decisions 646 Analysis of Political Risk 648 Financing International Business Operations 649 Funding of Transactions 650 Eximbank (Export-Import Bank) 650 Loans from the Parent Company or a Sister Affiliate 650 Eurodollar Loans 652 Eurobond Market 653 International Equity Markets 653 The International Finance Corporation 655 Some Unsettled Issues in International Finance 656 Summary 656 List of Terms 657 Discussion Questions 658 Practice Problems and Solutions 658 Problems 659 Web Exercise 660 S&P Problems 661 Appendix 21A Cash Flow Analysis and the Foreign Investment Decision 661

PART 6 i EXPANDING THE PERSPECTIVE OF CORPORATE FINANCE 20 External Growth through Mergers 612
Motives for Business Combinations 613 Financial Motives 613 Nonfinancial Motives 675 Motives of Selling Stockholders 675 Terms of Exchange 67 7 Cash Purchases 677 Stock-for-Stock Exchange 618 Portfolio Effect 679 Accounting Considerations in Mergers and Acquisitions 620 Negotiated versus Tendered Offers 627 Premium Offers and Stock Price Movements 623 Two-Step Buyout 624 Summary 625 List of Terms 625 Discussion Questions 625 Practice Problems and Solutions 626 Problems 627 Web Exercise 631 S&P Problems 632

Appendixes A-1
Appendix A Future Value of$l, FVIF A-2 Appendix B Present Value of$l, PVIF A-4 Appendix C Future Value of an Annuity of $1,FVIFA A-6 Appendix D Present Value of an Annuity of $1,PVIFA A-8

21 International Financial Management 633


The Multinational Corporation: Nature and Environment 636 Exporter 636 Licensing Agreement 636 Joint Venture 636 Fully Owned Foreign Subsidiary 636 Foreign Exchange Rates 637 Factors Influencing Exchange Rates 639

Glossary G Indexes 1-1

You might also like