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 FINANCIAL ANALYSIS AND PLANNING

1 The Goals and Functions of Financial

Management 4

2 Review of Accounting 26

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

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

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

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

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

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

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

XX11

Contents

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

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

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

13 Risk and Capital Budgeting 407

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

12 The Capital Budgeting Decision

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

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

xxiii

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

491

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
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

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

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

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

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

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

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

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

Glossary G
Indexes 1-1