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FIFTH EDITION

Foundations of Finance
THE LOGIC AND PRACTICE OF FINANCIAL MANAGEMENT
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FIFTH EDITION

Foundations of Finance
THE LOGIC AND PRACTICE OF FINANCIAL MANAGEMENT

ARTHUR J. KEOWN

Virginia Polytechnic Institute and State University


R. B. Pamplin Professor of Finance

JOHN D. MARTIN

Baylor University
Professor of Finance
Carr P. Collins Chair in Finance

J. WILLIAM PETTY

Baylor University
Professor of Finance
W. W. Caruth Chair in Entrepreneurship

D A V I D F. S C O T T, J R .

University of Central Florida


Executive Director, Dr. Phillips Institute
for the Study of American Business Activity
and Professor of Finance

Upper Saddle River, New Jersey 07458


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Library of Congress Cataloging-in-Publication Data


Foundations of finance : the logic and practice of financial management / Arthur J. Keown
... [et al.].5th ed.
p. cm.
Includes bibliographical references and indexes.
ISBN 0-13-185605-7
1. CorporationsFinance. I. Keown, Arthur J.

HG4026 .F67 2006


658.15--dc22 2005045934

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To my parents, from whom I learned the most.


Arthur J. Keown

To my grandson Luke and his little brother


who arrives in June 2005.
John D. Martin

To Bobbye and LaVerne, loving and supportive wives


to my brothers and the most wonderful sisters
I could ever have.
J. William Petty

To my sister, Dianne, and her husband, Ron,


who have been both supportive family
and engaging friends over so many years.
David F. Scott, Jr.
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ABOUT THE AUTHORS

A R T H U R J . K E O W N is the R. B. Pamplin Professor of Finance at Virginia Polytechnic


Institute and State University. He received his bachelors degree from Ohio Wesleyan
University, his M.B.A. from the University of Michigan, and his doctorate from Indiana
University. An award-winning teacher, he is a member of the Academy of Teaching
Excellence; has received five Certificates of Teaching Excellence at Virginia Tech, the W. E.
Wine Award for Teaching Excellence, and the Alumni Teaching Excellence Award; and in
1999 received the Outstanding Faculty Award from the State of Virginia. Professor Keown is
widely published in academic journals. His work has appeared in The Journal of Finance, the
Journal of Financial Economics, the Journal of Financial and Quantitative Analysis, The Journal of
Financial Research, the Journal of Banking and Finance, Financial Management, the Journal
of Portfolio Management, and many others. In addition to Foundations of Finance, two other of
his books are widely used in college finance classes all over the countryBasic Financial
Management and Personal Finance: Turning Money into Wealth. Professor Keown is a Fellow of
the Decision Sciences Institute, a member of the Board of Directors of the Financial
Management Association, and former head of the finance department at Virginia Tech. In
addition, he recently served as the co-editor of The Journal of Financial Research for six and a
half years and as the co-editor of the Financial Management Associations Survey and Synthesis
series for six years. He lives with his wife and two children in Blacksburg, Virginia, where he
collects original art from Mad Magazine.

J O H N D . M A R T I N is Professor of Finance and the holder of the Carr P. Collins Chair of


Finance at Baylor University. Dr. Martin came to Baylor University in 1998 from the
University of Texas at Austin where he taught for nineteen years and was the Margaret
and Eugene McDermott Centennial Professor of Finance. He teaches corporate finance and
his research interests are in corporate governance, the evaluation of firm performance,
and the design of incentive compensation plans. Dr. Martin has published widely in acade-
mic journals including the Journal of Financial Economics, The Journal of Finance, Journal of
Monetary Economics, Journal of Financial and Quantitative Analysis, Journal of Corporate
Finance, Financial Management, and Management Science. His work has also appeared in a
number of professional publications including Directors and Boards, the Financial Analysts
Journal, the Journal of Portfolio Management, and the Journal of Applied Corporate Finance. In
addition to this book Dr. Martin is co-author of nine books including Financial Management
(9th ed., Prentice Hall), The Theory of Finance (Dryden Press), Financial Analysis (2nd ed.,
McGraw Hill), and Value Based Management (Harvard Business School Press), and he is cur-
rently writing a book on interest rate modeling. He serves on the editorial boards of eight
journals and has delivered executive education programs for a number of firms including
Shell Chemical, Shell E&P, Texas Instruments, and The Associates.

J . W I L L I A M P E T T Y is Professor of Finance and the W. W. Caruth Chairholder of


Entrepreneurship at Baylor University. He holds a Ph.D. and M.B.A. from the University
of Texas at Austin, and a B.S. from Abilene Christian University. He has taught at Virginia
Tech University and Texas Tech University, and served as the dean of the business school at
Abilene Christian University. His research interests include the creation and financing of
high-potential entrepreneurial firms and shareholder value-based management. He is also
the Director of the Entrepreneurship Program at Baylor University. He has served as the
co-editor for the Journal of Financial Research and the editor of the Journal of Entrepreneurial
and Small Business Finance. He has published in a number of finance journals and is the co-
author of two leading corporate finance textbooks, Basic Financial Management and
Foundations of Finance, and co-author of a widely used text, Small Business Management. Dr.
Petty serves on the board of a publicly traded oil and gas firm. He has also served as a sub-
ject matter expert on a best-practices study by the American Productivity and Quality
Center on the topic of shareholder value-based management. He recently served on a
research team for the Australian Department of Industry to study the feasibility of estab-
lishing a public equity market for small and medium-sized enterprises in Australia.
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ABOUT THE AUTHORS vii

D A V I D F. S C O T T, J R . received his Ph.D. from the University of Florida, an M.B.A.


from the University of Detroit, and a B.S.B.A. from the University of Akron. He holds the
Phillips-Schenck Chair in American Private Enterprise, is Executive Director, Dr. Phillips
Institute for the Study of American Business Activity, and is Professor of Finance at the
University of Central Florida. From 1977 to 1982 he was Area Coordinator, then Head,
Department of Finance, Insurance, and Business Law at Virginia Polytechnic Institute and
State University. During 19851986 he was President of the Financial Management
Association, an international group with 9,000 members. He was a member of the Board of
Trustees of FMA from 1986 to 1993.
Dr. Scott is a member of the Board of Directors of CompBenefits Corporation,
headquartered in Atlanta, Georgia. He is a past member of the local Board of Directors of
BankFIRST-Goldenrod (Florida), which specializes in commercial banking services for
small businesses. He served on the Investment Policy Committee of the University of
Central Florida Foundation for over 10 years. Dr. Scott is also past founding co-editor
of the Journal of Financial Research, past associate editor for the Akron Business and Economic
Review, and past associate editor for Financial Management. He is past president of the
Southern Finance Association. In addition to Foundations of Finance, Dr. Scott is co-author
of Basic Financial Management, Cases in Finance, and Guide to Financial Analysis. He is widely
published in academic journals including Financial Management, Engineering Economist,
Journal of Financial and Quantitative Analysis, Business Economics, and many others.
Dr. Scotts op-ed and research pieces have appeared in several leading outlets intended
for consumer and practitioner audiences. These include USA Today, The Miami Herald, The
St. Petersburg Times, Florida Today, Orlando Sentinel, and Florida Trend.
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BRIEF CONTENTS

PART 1: THE SCOPE AND ENVIRONMENT


OF FINANCIAL MANAGEMENT 2

CHAPTER 1
An Introduction to the Foundations of Financial ManagementThe Ties That Bind 5

CHAPTER 2
The Financial Markets and Interest Rates 31

CHAPTER 3
Understanding Financial Statements and Cash Flows 73

CHAPTER 4
Evaluating a Firms Financial Performance 101

PART 2: VALUATION OF FINANCIAL ASSETS 134

CHAPTER 5
The Time Value of Money 137

CHAPTER 6
The Meaning and Measurement of Risk and Return 173

CHAPTER 7
Valuation and Characteristics of Bonds 205

CHAPTER 8
Valuation and Characteristics of Stock 231

PART 3: INVESTMENT IN LONG-TERM ASSETS 256

CHAPTER 9
Capital-Budgeting Techniques and Practice 259

CHAPTER 10
Cash Flows and Other Topics in Capital Budgeting 295

CHAPTER 11
Cost of Capital 329

PART 4: CAPITAL STRUCTURE


AND DIVIDEND POLICY 364

CHAPTER 12
Determining the Financing Mix 367

CHAPTER 13
Dividend Policy and Internal Financing 415

ix
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x BRIEF CONTENTS

PART 5: WORKING-CAPITAL MANAGEMENT


AND INTERNATIONAL BUSINESS FINANCE 444

CHAPTER 14
Short-Term Financial Planning 447

CHAPTER 15
Working-Capital Management 469

CHAPTER 16
Current Asset Management 491

CHAPTER 17
International Business Finance 527
APPENDIX A Using a Calculator 551
APPENDIX B Compound Sum of $1 FVIFi%, n years 563
APPENDIX C Present Value of $1 PVIFi%, n years 565
APPENDIX D Sum of an Annuity of $1 for n Periods FVIFAi%, n years 567
APPENDIX E Present Value of an Annuity of $1 for n Periods PVIFAi%, n years 569
APPENDIX F Check Figures for Selected End-of-Chapter Study Problems 571

Glossary 575

Indexes 585
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CONTENTS

About the Authors vi


Preface xxi

PA RT: 1 T H E S C O P E A N D E N V I R O N M E N T
OF FINANCIAL MANAGEMENT 2

CHAPTER 1
An Introduction to the Foundations of Financial Management
The Ties That Bind 5
Goal of the Firm 6
Legal Forms of Business Organization 7
AN ENTREPRENEURS PERSPECTIVE: Limited Liability and the Entrepreneur 10
Federal Income Taxation 11
Ten Principles That Form the Foundations of Financial Management 16
PRINCIPLE 1: The RiskReturn Trade-OffWe Wont Take On Additional Risk Unless
We Expect to Be Compensated with Additional Return 16
PRINCIPLE 2: The Time Value of MoneyA Dollar Received Today Is Worth More
Than a Dollar Received in the Future 17
PRINCIPLE 3: CashNot ProfitsIs King 17
PRINCIPLE 4: Incremental Cash FlowsIts Only What Changes That Counts 17
PRINCIPLE 5: The Curse of Competitive MarketsWhy Its Hard to Find
Exceptionally Profitable Projects 18
PRINCIPLE 6: Efficient Capital MarketsThe Markets Are Quick and the Prices Are
Right 19
PRINCIPLE 7: The Agency ProblemManagers Wont Work for the Owners Unless Its
in Their Best Interest 20
PRINCIPLE 8: Taxes Bias Business Decisions 20
PRINCIPLE 9: All Risk Is Not EqualSome Risk Can Be Diversified Away, and Some
Cannot 21
PRINCIPLE 10: Ethical Behavior Is Doing the Right Thing, and Ethical Dilemmas Are
Everywhere in Finance 22
ETHICS IN FINANCIAL MANAGEMENT: The Enron Lessons: Trust 23
AN ENTREPRENEURS PERSPECTIVE: The Entrepreneur and Finance 24
Finance and the Multinational Firm: The New Role 24
Summary 25
Key Terms 26
Study Questions 26
Self-Test Problem 27
Study Problems 27
Comprehensive Problem 28
Self-Test Solution 29

CHAPTER 2
The Financial Markets and Interest Rates 31
The Financial Manager, Internal and External Funds, and Flexibility 34
The Mix of Corporate Securities Sold in the Capital Market 36

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Why Financial Markets Exist 37


Financing of Business: The Movement of Funds Through the Economy 39
Components of the U.S. Financial Market System 41
The Investment Banker 45
ACROSS THE HALL: Management and Selection Criteria
for an Investment Banker 48
Private Placements 48
Flotation Costs 50
Regulation 50
Rates of Return in the Financial Markets 55
Interest Rate Levels over Recent Periods 56
ACROSS THE HALL: EconomicsCommercial Banking and the Importance of
Interest Rates 59
Interest Rate Determinants in a Nutshell 60
The Term Structure of Interest Rates 63
Finance and the Multinational Firm: Efficient Financial Markets
and Intercountry Risk 67
Summary 67
Key Terms 69
Study Questions 69
Study Problems 70
Web Works 70
Comprehensive Problems 71

CHAPTER 3
Understanding Financial Statements and Cash Flows 73
Income Statement 74
FINANCIAL MANAGEMENT IN PRACTICE: Starbucks Corporation:
A Firm on the Go 76
Balance Sheet 77
ACROSS THE HALL: Want to Start a New Business?
Better Know Your Numbers 78
FINANCIAL MANAGEMENT IN PRACTICE: Being Profitable Is Vital: Just Ask Ford
Motor Company 81
Measuring Cash Flows 82
FINANCIAL MANAGEMENT IN PRACTICE: Profits and Cash Matter: The FedEx
Dilemma 86
FINANCIAL MANAGEMENT IN PRACTICE: Measuring Free Cash Flows: The Tyco
International Way 87
ETHICS IN FINANCIAL MANAGEMENT: Financial Scandals: European Style 88
Summary 89
Key Terms 90
Study Questions 91
Self-Test Problem 91
Study Problems 92
Web Works 96
Comprehensive Problem 97
Self-Test Solution 99
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CONTENTS xiii

CHAPTER 4
Evaluating a Firms Financial Performance 101
The Purpose of Financial Analysis 102
FINANCIAL MANAGEMENT IN PRACTICE: Only with Financial Analysis Can We Know
How We Are Doing 104
Measuring Key Financial Relationships 105
FINANCIAL MANAGEMENT IN PRACTICE: Keeping Your Eyes on the Numbers 111
FINANCIAL MANAGEMENT IN PRACTICE: Managing by the Numbers 113
FINANCIAL MANAGEMENT IN PRACTICE: Economic Value Added Used to Measure a
Firms Financial Performance 122
Limitations of Financial Ratio Analysis 122
Summary 123
Key Terms 124
Study Questions 125
Self-Test Problems 125
Study Problems 126
Web Works 131
Comprehensive Problem 131
Self-Test Solutions 132

PART 2: VALUATION OF FINANCIAL ASSETS 134

CHAPTER 5
The Time Value of Money 137
Compound Interest and Future Value 138
Tables, Calculators, and SpreadsheetsThree Alternatives to Solving Time Value of
Money Problems 140
Present Value 145
Annuities 149
Annuities Due 154
Compound Interest with Nonannual Periods 158
Present Value of an Uneven Stream 160
Perpetuities 161
The Multinational Firm: The Time Value of Money 161
Summary 162
Key Terms 163
Study Questions 163
Self-Test Problems 163
Study Problems 163
Web Works 169
Comprehensive Problem 170
Self-Test Solutions 171

CHAPTER 6
The Meaning and Measurement of Risk and Return 173
Expected Return Defined and Measured 174
Risk Defined and Measured 175
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FINANCIAL MANAGEMENT IN PRACTICE: Want Big and Risky Returns:


Think Small 178
Rates of Return: The Investors Experience 179
Risk and Diversification 181
ACROSS THE HALL: Bankers Have to Diversify Too 185
FINANCIAL MANAGEMENT IN PRACTICE: Do Stocks Always Give Higher Returns
Than Bonds? 191
The Investors Required Rate of Return 192
FINANCIAL MANAGEMENT IN PRACTICE: Does Beta Always Work? 194
Summary 195
Key Terms 196
Study Questions 196
Self-Test Problems 197
Study Problems 198
Web Works 200
Comprehensive Problem 200
Self-Test Solutions 202

CHAPTER 7
Valuation and Characteristics of Bonds 205
Types of Bonds 206
Terminology and Characteristics of Bonds 208
FINANCIAL MANAGEMENT IN PRACTICE: Co-Cos: A Good Deal for Whom? 211
Definitions of Value 211
Determinants of Value 212
FINANCIAL MANAGEMENT IN PRACTICE: Ethics: Keeping Perspective 214
Valuation: The Basic Process 214
Bond Valuation 215
Yield to Maturity 218
FINANCIAL MANAGEMENT IN PRACTICE: AT&T Bond Prices Fall Thanks to
WorldCom 219
Bond Valuation: Three Important Relationships 220
Summary 224
Key Terms 225
Study Questions 225
Self-Test Problems 225
Study Problems 225
Web Works 227
Comprehensive Problem 227
Self-Test Solutions 228

CHAPTER 8
Valuation and Characteristics of Stock 231
Preferred Stock 232
FINANCIAL MANAGEMENT IN PRACTICE: Reading a Stock Quote in the Wall Street
Journal 234
Common Stock 236
FINANCIAL MANAGEMENT IN PRACTICE: What Does a Stock Look Like? 238
FINANCIAL MANAGEMENT IN PRACTICE: What Do You Tell Your Shareholders? 239
The Stockholders Expected Rate of Return 247
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CONTENTS xv

Summary 251
Key Terms 252
Study Questions 252
Self-Test Problems 252
Study Problems 253
Web Works 254
Comprehensive Problem 255
Self-Test Solutions 255

PART 3: INVESTMENT IN LONG-TERM ASSETS 256

CHAPTER 9
Capital-Budgeting Techniques and Practice 259
Finding Profitable Projects 260
Capital-Budgeting Decision Criteria 261
FINANCIAL MANAGEMENT IN PRACTICE: Finding Profitable Projects in Competitive
MarketsCreating Them by Developing a Cost Advantage 263
ACROSS THE HALL: Marketing 266
Capital Rationing 276
Problems in Project Ranking: Capital Rationing, Mutually Exclusive Projects, and
Problems with the IRR 278
ETHICS IN FINANCIAL MANAGEMENT: The Financial Downside to Poor Ethical
Behavior 282
Ethics in Capital Budgeting 282
A Glance at Actual Capital-Budgeting Practices 283
Finance and the Multinational Firm: Capital Budgeting 284
Summary 284
Key Terms 286
Study Questions 286
Self-Test Problem 287
Study Problems 287
Web Works 291
Comprehensive Problem 291
Self-Test Solution 293

CHAPTER 10
Cash Flows and Other Topics in Capital Budgeting 295
Guidelines for Capital Budgeting 296
FINANCIAL MANAGEMENT IN PRACTICE: Universal Studios 299
An Overview of the Calculations of a Projects Free Cash Flows 299
ACROSS THE HALL: Marketing 306
Options in Capital Budgeting 308
Risk and the Investment Decision 310
Incorporating Risk into Capital Budgeting 313
Examining a Projects Risk Through Simulation 316
Finance and the Multinational Firm: Calculating Cash Flows and the International
Dimension of Risk 319
Summary 319
Key Terms 320
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Study Questions 320


Self-Test Problem 321
Study Problems 321
Web Work 325
Comprehensive Problem 325
Self-Test Solution 327

CHAPTER 11
Cost of Capital 329
The Cost of Capital: Key Definitions and Concepts 330
Determining Individual Costs of Capital 331
FINANCIAL MANAGEMENT IN PRACTICE: IPOs: Should a Firm Go Public? 338
The Weighted Average Cost of Capital 339
Calculating Divisional Costs of Capital: PepsiCo, Inc. 342
FINANCIAL MANAGEMENT IN PRACTICE: The Pillsbury Company Adopts EVA with
a Grassroots Education Program 343
Using a Firms Cost of Capital to Evaluate New Capital Investments 344
Shareholder ValueBased Management 346
FINANCIAL MANAGEMENT IN PRACTICE: New Users Explain Their Goals and
Objectives in Adopting EVA 348
Finance and the Multinational Firm: Why Do Interest Rates Differ Between
Countries? 351
FINANCIAL MANAGEMENT IN PRACTICE: Tying Incentive Compensation to
Economic Value Added 352
Summary 353
Key Terms 356
Study Questions 356
Self-Test Problems 356
Study Problems 357
Web Works 361
Comprehensive Problem 361
Self-Test Solutions 362

PART 4: CAPITAL STRUCTURE


AND DIVIDEND POLICY 364

CHAPTER 12
Determining the Financing Mix 367
Business and Financial Risk 369
Break-Even Analysis 370
ACROSS THE HALL: AccountingCost Structure, Forecasting,
and Investment 371
FINANCIAL MANAGEMENT IN PRACTICE: General Motors: Pricing Strategy in a Slow
Aggregate Economy 377
Operating Leverage 377
Financial Leverage 380
Combination of Operating and Financial Leverage 383
FINANCIAL MANAGEMENT IN PRACTICE: Coca-Cola Financial Policies 385
Planning the Financing Mix 385
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CONTENTS xvii

FINANCIAL MANAGEMENT IN PRACTICE: The Enron Lessons: Leverage 386


A Quick Look at Capital Structure Theory 387
FINANCIAL MANAGEMENT IN PRACTICE: Georgia-Pacific on Capital Structure 396
Basic Tools of Capital Structure Management 396
FINANCIAL MANAGEMENT IN PRACTICE: The Walt Disney Company on Capital
Costs and Capital Structure 401
A Glance at Actual Capital Structure Management 402
Finance and the Multinational Firm: Business Risk and Global Sales 404
Summary 404
Key Terms 406
Study Questions 406
Self-Test Problem 407
Study Problems 407
Web Works 411
Comprehensive Problems 412
Self-Test Solution 413

CHAPTER 13
Dividend Policy and Internal Financing 415
Key Terms 416
Does Dividend Policy Affect Stock Price? 417
The Dividend Decision in Practice 426
Alternative Dividend Policies 427
Dividend Payment Procedures 430
Stock Dividends and Stock Splits 431
Stock Repurchases 433
FINANCIAL MANAGEMENT IN PRACTICE: Many Concerns Use Excess Cash to
Repurchase Their Shares 435
Finance and the Multinational Firm: The Case of Low-Dividend Payments; So Where
Do We Invest? 436
Summary 438
Key Terms 439
Study Questions 439
Self-Test Problems 440
Study Problems 440
Web Works 441
Comprehensive Problem 442
Self-Test Solutions 443

PART 5: WORKING-CAPITAL MANAGEMENT


AND INTERNATIONAL BUSINESS FINANCE 444

CHAPTER 14
Short-Term Financial Planning 447
Financial Forecasting 448
The Sustainable Rate of Growth 453
FINANCIAL MANAGEMENT IN PRACTICE: Sustainable GrowthA Broader
Perspective at DuPont 454
Limitations of the Percent of Sales Forecast Method 454
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xviii CONTENTS

FINANCIAL MANAGEMENT IN PRACTICE: To Bribe or Not to Bribe 456


Constructing and Using a Cash Budget 456
FINANCIAL MANAGEMENT IN PRACTICE: Being Honest About the Uncertainty of the
Future 458
Summary 458
Key Terms 459
Study Questions 459
Self-Test Problems 459
Study Problems 460
Web Works 465
Comprehensive Problem 466
Self-Test Solutions 467

CHAPTER 15
Working-Capital Management 469
Managing Current Assets and Liabilities 470
Appropriate Level of Working Capital 471
Estimation of the Cost of Short-Term Credit 474
Sources of Short-Term Credit 475
FINANCIAL MANAGEMENT IN PRACTICE: Managing Working Capital by Trimming
Receivables 476
Multinational Working-Capital Management 483
Summary 484
Key Terms 485
Study Questions 485
Self-Test Problems 486
Study Problems 486
Web Works 488
Self-Test Solutions 489

CHAPTER 16
Current Asset Management 491
Why a Company Holds Cash 492
Cash Management Objectives and Decisions 494
Collection and Disbursement Procedures 495
Evaluation of Costs of Cash Management Services 501
Composition of Marketable-Securities Portfolio 502
Accounts-Receivable Management 508
Inventory Management 511
Summary 517
Key Terms 518
Study Questions 518
Self-Test Problems 518
Study Problems 519
Web Works 523
Comprehensive Problem 523
Self-Test Solutions 524
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CONTENTS xix

CHAPTER 17
International Business Finance 527
The Globalization of Product and Financial Markets 528
Exchange Rates 528
ACROSS THE HALL: Marketing 536
Interest-Rate Parity Theory 536
FINANCIAL MANAGEMENT IN PRACTICE: The Euro Has Yet to Spark Hoped-For
Financial Revolution 537
Purchasing-Power Parity Theory 537
Exposure to Exchange Rate Risk 539
Multinational Working-Capital Management 542
International Financing and Capital Structure Decisions 543
Direct Foreign Investment 544
Summary 546
Key Terms 546
Study Questions 547
Self-Test Problem 547
Study Problems 548
Web Works 548
Comprehensive Problem 548
Self-Test Solution 549
Appendixes 551

A P P E N D I X A Using a Calculator 551


A P P E N D I X B Compound Sum of $1 FVIFi%, n years 563
A P P E N D I X C Present Value of $1 PVIFi%, n years 565
A P P E N D I X D Sum of an Annuity of $1 for n Periods FVIFAi%, n years 567
A P P E N D I X E Present Value of an Annuity of $1 for n Periods PVIFAi%, n years 569
A P P E N D I X F Check Figures for Selected End-of-Chapter Study Problems 571

Glossary 575

Indexes 585
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PREFACE

In finance, our goal is to create wealth. This is done by providing customers with the best
product and service possible, and it is the market response that determines whether we
reach our goal. We are very proud of the market reaction to Foundations of Finance; the
markets response has been overwhelming. With its success comes an even greater
responsibility to deliver the finest possible textbook and supplementary package possible.
We have done this with a two-pronged approach of refinement, based on users comments,
and of remaining the innovative leaders in the field, focusing on value-added innovations.
Foundations of Finance has gained the reputation for being intuitiveallowing the
reader to see the forest through the treesand lively and easy to read. In the fifth
edition of Foundations of Finance, we have tried to build on these strengths, introducing the
latest concepts and developments in finance in a practical and intuitive manner.

PEDAGOGY THAT WORKS

This book provides students with a conceptual understanding of the financial decision-
making process, rather than just an introduction to the tools and techniques of finance. For
the student, it is all too easy to lose sight of the logic that drives finance and focus instead
on memorizing formulas and procedures. As a result, students have a difficult time
understanding the interrelationships among the topics covered. Moreover, later in life
when the problems encountered do not match the textbook presentation, students may find
themselves unprepared to abstract from what they learned. To overcome this problem, the
opening chapter presents 10 underlying principles of finance, which serve as a springboard
for the chapters and topics that follow. In essence, the student is presented with a cohesive,
interrelated perspective from which future problems can be approached.
With a focus on the big picture,
we provide an introduction to Objective TEN PRINCIPLES THAT FORM THE FOUNDATIONS
financial decision making rooted in
4
OF FINANCIAL MANAGEMENT
current financial theory and in the
To the first-time student of finance, the subject matter may seem like a collection of unre-
current state of world economic lated decision rules. This could not be further from the truth. In fact, our decision rules,
conditions. This focus is perhaps most and the logic that underlies them, spring from 10 simple principles that do not require
knowledge of finance to understand. However, although it is not necessary to understand finance
apparent in the attention given to the in order to understand these principles, it is necessary to understand these principles in order to
capital markets and their influence on understand finance. Keep in mind that although these principles may at first appear simple or
even trivial, they provide the driving force behind all that follows. These principles weave
corporate financial decisions. What together concepts and techniques presented in this text, thereby allowing us to focus on the
results is an introductory treatment of logic underlying the practice of financial management.
a discipline rather than the treatment
PRINCIPLE 1
of a series of isolated problems that The RiskReturn Trade-OffWe Wont Take On Additional Risk
Unless We Expect to Be Compensated with Additional Return
face the financial manager. The goal of
this text is not merely to teach the At some point we have all saved some money. Why have we done this? The answer is
tools of a discipline or trade but also to simple: to expand our future consumption opportunities. We are able to invest those sav-
ings and earn a return on our dollars because some people would rather forgo future con-
enable students to abstract what is sumption opportunities to consume more now. Maybe theyre borrowing money to open a
learned to new and yet unforeseen new business or a company is borrowing money to build a new plant. Assuming there are a
lot of different people who would like to use our savings, how do we decide where to put
problemsin short, to educate the our money?
student in finance.

INNOVATIONS AND DISTINCTIVE FEATURES


IN THE FOURTH EDITION

PA R T- O P E N I N G I N T E R V I E W S WITH BUSINESS PROFESSIONALS


These give students in-the-trenches insights into the application of theory to practice in
the real world and provide perspective for anyone who is planning a career in business.

xxi
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xxii P R E FA C E

REAL-WORLD OPENING VIGNETTES


Each chapter begins with a story about a current, real-world company faced with a financial decision
related to the chapter material that follows. These vignettes have been carefully prepared to stimulate
student interest in the topic to come and can be used as a lecture tool to provoke class discussion.

NEW AND IMPROVED PROBLEM SETS


The end-of-chapter study problem sets have been improved and expanded to allow for a wider range
of student problems.

NEW WEB WORKS INTERNET PROBLEMS


Internet problems have been introduced at the end of each chapter. These problems direct the
student to Internet sites that allow them to explore financial issues and solve financial problems using
the Web.

ACROSS
THE HALL
BANKERS HAVE TO DIVERSIFY TOO N E W AC R O S S THE H A L L
Robert A. Bennett, a banker, says that diversifying is important
for any business, including banks. He makes the point that
indeed was a severe blow that was primarily responsible for the
7% decline in Citis year-overs-year first-quarter earnings.
BOXES
bankers need to understand the importance of diversifying, But as Sandy Weill, Citis CEO, said in the companys earnings
especially in uncertain times. report: This is precisely the kind of market that demonstrates A new box feature titled Across the Hall
the power of our franchise. The strength and diversity of our
In the quest to increase their earnings, many banks forgot the
importance of diversification. Rushing into the moments
earnings by business, geography, and customer helped to deliver has been introduced in this edition of
a strong bottom line in a period of market uncertainty.
hottest businesses, they abandoned activities that at the time
seemed lackluster. The go-go businesses of the 1990s reflected Considering the plunge in investment banking income, things Foundations of Finance. This box draws on
could have been a lot worse. Despite the drop in income from
the stock markets boom: investment banking, stock brokerage,
wealth management and equity investment. On the other side, investment activities, Citi succeeded in getting a 22.5% return on professionals and their experiences from
equity. Thats even better than its 22% return last year, and better
banks were dumping what seemed to be slow-growth activities:
mortgage banking, auto financing and credit cards. than its average ROE of 19% for the three-year period 19982000. marketing, management, and accounting
In these uncertain times it is unclear which way to turn. It appears As David S. Berry, head of research at Keefe, Bruyette &
Woods, put it: Citigroup again demonstrated the benefits of
to illustrate how the material being
the best gamble is to spread your bets across a wide spectrum.
Citigroup is a case in point. The decline in the stock markets
diversification and leadership across its business lines.
presented pertains to what they do.
walloped the earnings of its investment banking activities, Source: Robert A. Bennett, When in Doubt, Diversify, U.S. Banker, vol. 11,
where income dropped $497 million in the first quarter. That, no. 5 (May 2001), p. 6.

AN ENTREPRENEURS
PERSPECTIVE
THE ENTREPRENEUR AND FINANCE
Do you ever think about wanting to someday own your own the capital to own all the resources that are needed. So the
business? Does being an entrepreneur have any appeal to you? entrepreneur must have access to resources but usually can-
Well, it does for a lot of people. During the past decade, starting not afford to own them. Its what we call bootstrapping. The
N E W A N E N T R E P R E N E U R S and growing companies have been the preferred avenue many
have chosen for careers. In fact, while many of the large compa-
goal is to do more with less.
Launch the venture. All the planning in the world is not
PERSPECTIVE BOXES nies are reducing the number of employees, smaller companies
are creating new jobs by the thousands. A lot of individuals have
enough. The entrepreneur must be action oriented. It
requires a can do spirit.
thought that there was greater security in working with a big Grow the business. A business has to grow if it is to be suc-
A new box feature titled An Entrepreneurs company, only to be disillusioned in the end when they were cessful. Frequently, the firm will not break even for several
informed that Friday is your last day. years, which means that we will be burning up cash each
Perspective that highlights issues faced by Defining an entrepreneur is not an easy thing to do. But we month. Being able to survive during the time that cash
small and medium-sized firms has been can say with some clarity what entrepreneurship is about.
Entrepreneurship has been defined as a relentless pursuit of
flows are negative is no easy task. If we grow too slow, we
lose, but also if we grow too fast, we may lose as well.
introduced. These boxes look at finance opportunity for the purpose of creating value, without concern
for the resources owned.
During this time, additional capital will be needed, which
requires that we know how to value the firm and how to
from the point of view of someone who To be successful, the entrepreneurial process requires that structure financing.
the entrepreneur be able to: Exit the business. If a venture has been successful, the entre-
would like to start his or her own successful Identify a good opportunity. Oftentimes we may have a good
preneur will have created economic value that is locked up
in the business. At some point in time, the entrepreneur will
business. idea, but it may not be a good opportunity. Opportunities
want to capture the value that has been created by the busi-
are market driven. There must be enough customers who
ness. It will be time to harvest.
want to buy our product or service at a price that covers our
expenses and leaves an attractive profitno matter how To be successful as an entrepreneur requires an understanding
much we may like the idea. of finance. At the appropriate places in Financial Management,
Gain access to the resources needed. For any venture, there we will be presenting how finance relates to the entrepreneur-
are critical resourceshuman, financial, and physicalthat ial journey. It is an interesting topic that we think you will
must be available. The entrepreneur usually does not have enjoy.

EXCEL SPREADSHEETS
Excel spreadsheets are used to move money through time, deal with valuation of financial
assets, and evaluate capital budgeting projects. These spreadsheet solutions are integrated
throughout the text with spreadsheet problems now appearing at the end of various chapters,
where appropriate.
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P R E FA C E xxiii

USE OF AN I N T E G R AT E D L E A R N I N G S YS T E M
The text is organized around the learning objectives that appear at the beginning of each
chapter to provide the instructor and student with an easy-to-use integrated learning system.
Numbered icons identifying each objective appear next to the related material throughout the
text and in the summary, allowing easy location of material related to each objective.

W H AT S A H E A D
W H AT S A H E A D
These features allow students to preview In this chapter, we lay a foundation for the entire and describe the golden thread that ties everything
whats coming up in the chapter. They book by discussing what finance is and then explain- together: the 10 basic principles of finance. Finally,
ing the key goal that guides financial decision mak- we briefly look at what has led to the rise in multina-
include real-world examples to help students ing: maximization of shareholder wealth. We discuss tional corporations.
understand the relevance of the concepts to the legal and tax environment of financial decisions

the financial world.

PAU S E AND REFLECT


PAUSE AND REFLECT
A timeline often makes it easier to understand time value of money problems. By In-text inserts appear throughout and focus the
visually plotting the flow of money, you can better determine which formula to use. students attention on the big picture. These inserts
Arrows placed above the line are inflows, whereas arrows below the line represent
outflows. One thing is certain: Timelines reduce errors. help students identify the interrelationships and
motivating factors behind core concepts.

EXAMPLE
If we place $1,000 in a savings account paying 5 percent interest compounded annually,
how much will our account accrue to in 10 years? Substituting PV $1,000, i 5 per-
I N T E G R AT E D E X A M P L E S cent, and n 10 years into equation (5-6), we get
These provide students with real-world examples to help FVn PV(1 + i)n
$1,000(1 + .05)10
them apply the concepts presented in each chapter. $1,000(1.62889)
$1,628.89
Thus, at the end of 10 years we will have $1,628.89 in our savings account.

ETHICS IN
FINANCIAL MANAGEMENT
THE ENRON LESSONS: TRUST
The bankruptcy and failure of the Enron Corporation on for a series of limited partnerships used by Enron to finance
December 2, 2001, shook the investment community to its very its investments and hedge certain investment returns. There
core and resulted in congressional hearings that could lead to were times when he represented the interests of Enron in
new regulations with far-reaching implications. Enrons failure circumstances that were in direct conflict with the interests
provides a sober warning to employees and investors and a valu- of the partners to the partnerships. It is still not clear how he
able set of lessons for students of business. The lesson we offer handled these circumstances, but the source of concern to
here reaches far beyond corporate finance and touches on fun- Enrons shareholders is obvious.
damental principles that have always been true but are some- Were corporate insiders (executives) selling their stock
times forgotten. based on their privileged knowledge of the firms true finan-
cial condition during the months prior to the firms failure,
Lesson: Trust and Credibility Are Essential
to Business Success
while outside investors were being duped into holding their
shares? Allegations abound that top corporate executives at
EXTENSIVE COVERAGE
The viability of any firm hinges critically on the firms credibil-
ity with its customers, employees, regulators, investors, and
Enron were selling their shares long before other employees
and outside investors knew how serious the firms problems OF ETHICS
even to some degree, competitors. This is particularly critical were. Regardless of the outcome in the Enron case, this
for a trading company such as Enron, whose primary business
rests on the willingness of the firms counterpart with whom it
raises a serious dilemma for investors, who cannot know as
much about the financial condition of the firms in which
Ethics is covered as a core principle and
trades to trust in Enrons ability to be there when the time they invest as the managers know. Ethics in Financial Management boxes appear
to settle up arrives. When the faith of the investment commu- Can auditing firms that accept consulting engagements
nity was tested with the revelation of losses from some of with their audit clients be truly independent, or is that inde- throughout. These show students that ethical
Enrons largest investments and the subsequent disclosure pendence compromised? The Enron failure has called into
of Enrons off-balance-sheet liabilities, Enrons trading business question the wisdom of relying on external auditing firms behavior is doing the right thing and that
evaporated. that are beholden to the firms they audit, both for their
We also were reminded of the fact that investors must continued employment as an auditor and for consulting fees ethical dilemmas are everywhere in finance.
believe that a firms published financial reports are a fair repre- that can sometimes dwarf their audit fees.
sentation of the firms financial condition. Without this trust, Finally, investors often rely on the opinions of equity ana-
outside investors would refuse to invest in the shares of publicly lysts. Investors make the assumption that the analysts are
traded firms, and financial markets would collapse.a offering unfettered, independent opinions of a companys
Trust between two entities is hard to sustain when one of financial prospects. However, in many cases the analysts
the parties has dual and conflicting motives. We refer to the work for investment banks that, in turn, rely on investment-
presence of multiple motives as a conflict of interest, and the banking fees from the very companies the analysts cover.
potential for conflict-of-interest problems was in abundance The potential conflict of interest is obvious.
as Enron fell to earth. Some of the following sources of con-
flict apply only to Enron, whereas others apply to many a This is simply a recasting of the famous result from microeconomics stating

firms: that where informational asymmetry problems between buyers and sellers are
extreme, markets will collapse [George Akerlof, The Market for Lemons:
Enrons chief financial officer (CFO) attempted to serve two Qualitative Uncertainty and the Market Mechanism, Quarterly Journal of
masters when he was both the CFO and the general partner Economics, 84 (1970), pp. 488500].
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xxiv P R E FA C E

CONCEPT CHECKS
CONCEPT CHECK At the end of most major sections, concept checks
1. What is an amortized loan? highlight the key ideas just presented and allow students
to test their understanding of the material.

B A C K T O T H E F O U N D AT I O N S

Valuing common stock is no different from valuing preferred stock; only the pattern of the cash flows
BACK TO THE F O U N DAT I O N S changes. Thus, the valuation of common stock relies on the same three principles developed in
Chapter 1 that were used in valuing preferred stock:
These in-text inserts appear throughout to allow the
Principle 1: The RiskReturn Trade-OffWe Wont Take on Additional Risk Unless We Expect
student to take time out and reflect on the meaning of the to Be Compensated with Additional Return.
material just presented. The use of these inserts, coupled Principle 2: The Time Value of MoneyA Dollar Received Today Is Worth More Than a Dollar
with the use of the 10 principles, keeps the student Received in the Future.

focused on the interrelationships and motivating factors Principle 3: CashNot ProfitsIs King.

behind the concepts. Determining the economic worth or value of an asset always relies on these three principles. Without
them, we would have no basis for explaining value. With them, we can know that the amount and timing of
cash, not earnings, drives value. Also, we must be rewarded for taking risk; otherwise, we will not invest.

COMPREHENSIVE PROBLEM

For your job as the business reporter for a local newspaper, you are given the task of putting
together a series of articles that explain the power of the time value of money to your readers. Your
editor would like you to address several specific questions in addition to demonstrating for the read-
ership the use of time value of money techniques by applying them to several problems. What
would be your response to the following memorandum from your editor?
To: Business Reporter
From: Perry White, Editor, Daily Planet
Re: Upcoming Series on the Importance and Power of the Time Value of Money
In your upcoming series on the time value of money, I would like to make sure you cover several COMPREHENSIVE
specific points. In addition, before you begin this assignment, I want to make sure we are all reading
from the same script, as accuracy has always been the cornerstone of the Daily Planet. In this regard, END-OF-CHAPTER PROBLEMS
Id like a response to the following questions before we proceed:
a. What is the relationship between discounting and compounding? A comprehensive problem appears at the end of
b. What is the relationship between the PVIFi, n and PVIFAi, n? almost every chapter, covering all the major topics
c. 1. What will $5,000 invested for 10 years at 8 percent compounded annually grow to?
2. How many years will it take $400 to grow to $1,671 if it is invested at 10 percent com- included in that chapter. This comprehensive problem
pounded annually?
3. At what rate would $1,000 have to be invested to grow to $4,046 in 10 years?
can be used as a lecture or review tool by the professor.
d. Calculate the future sum of $1,000, given that it will be held in the bank for 5 years and earn For the students, it provides an opportunity to apply
10 percent compounded semiannually.
e. What is an annuity due? How does this differ from an ordinary annuity? all the concepts presented within the chapter in a
f. What is the present value of an ordinary annuity of $1,000 per year for 7 years dis- realistic setting, thereby strengthening their
counted back to the present at 10 percent? What would be the present value if it were
an annuity due? understanding of the material.
g. What is the future value of an ordinary annuity of $1,000 per year for 7 years compounded
at 10 percent? What would be the future value if it were an annuity due?
h. You have just borrowed $100,000, and you agree to pay it back over the next 25 years in 25
equal end-of-year annual payments that include the principal payments plus 10 percent
compound interest on the unpaid balance. What will be the size of these payments?
i. What is the present value of a $1,000 perpetuity discounted back to the present at 8 percent?
j. What is the present value of a $1,000 annuity for 10 years, with the first payment occurring
at the end of year 10 (that is, ten $1,000 payments occurring at the end of year 10 through
year 19), given an appropriate discount rate of 10 percent?
k. Given a 10 percent discount rate, what is the present value of a perpetuity of $1,000 per year
if the first payment does not begin until the end of year 10?

KEY TERMS IDENTIFIED IN THE MARGINS


Key terms are called out in the margin and highlighted in the text. They can also be found in
the glossary in the back of the book with definitions, making it easier for the students to check
their understanding of key terms. At the end of each chapter, key terms are listed along with
page numbers as a study checklist for students.
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P R E FA C E xxv

F I N A N C I A L C A L C U L ATO R S
The use of financial calculators has been integrated throughout this text, especially with
respect to the presentation of the time value of money. Where appropriate, calculator
solutions appear in the margin.

C O N T E N T U P DAT I N G
In response to both the continued development of financial thought and reviewer
comments, changes have been made in the text. Some of these changes include:

C H A P T E R 1 A N I N T R O D U C T I O N T O T H E F O U N D AT I O N S O F F I N A N C I A L
M A N A G E M E N T T H E T I E S T H AT B I N D
The material in this chapter was updated and revised to reflect changes in the personal tax
code that lowered the personal tax rate on dividend income and thereby lessened the
impact of the double taxation of corporate dividends. This chapter also includes an
expanded discussion of S-type corporations and limited liability companies (LLC). In
addition, an Entrepreneurs Perspective box dealing with difficulties that entrepreneurs
face in raising capital was added.

C H A P T E R 2 T H E F I N A N C I A L M A R K E T S A N D I N T E R E S T R AT E S
Several changes, updates, and additions are spread throughout this chapter in order to
make it more lively and relevant to readers. Many of the alterations are in response to
reviewer suggestions. The chapter opens with a review of the past six interest rate cycles
with emphasis on (1) the immediate past recession that began in March 2001, (2) the
ultimate business expansion that led to the tightening of monetary policy commencing in
June 2004, and (3) developments related to the corporate cost of capital through the
opportunity cost of funds concept. Along this line, changes in the federal funds target rate
and the commercial bank prime lending rate are chronicled from 1994 to 2004.
A new section is provided on the Public Company Accounting Reform and Investor
Protection Act (SarbanesOxley Act of 2002). The material on SarbanesOxley is related to
financial controls, ethics in finance, and corporate governance. The creation of the Public
Company Accounting Oversight Board is detailed.
New boxes entitled Across the Hall are provided on both investment banking and
commercial banking. These are related to the need for the student to acquire a basic
understanding of business finance, regardless of that students undergraduate major. Both
of these new boxes were written by practicing corporate executives.

C H A P T E R 3 U N D E R S TA N D I N G F I N A N C I A L S TAT E M E N T S
AND CASH FLOWS
The presentation of the financial statements has been revised to be very intuitive and easy to
follow with illustrations that will keep the student interested in the material. Also, at the
request of adopters, the presentation of free cash flows was simplified to help the student grasp
this important concept without having to spend unproductive time in computations. The
result was a more intuitive presentation of the meaning and calculation of free cash flows.

C H A P T E R 4 E V A L U AT I N G A F I R M S F I N A N C I A L S TAT E M E N T S
The financial analysis in this chapter uses the traditional ratios based on accounting data
but then adds market-value ratios to connect the accounting data with the firms market
value. We then explain how to interpret the market-value ratios in terms of managements
performance at creating shareholder value. Finally, we use Economic Value Added to
help the student better understand how management creates shareholder value.

C H A P T E R 5 T H E T I M E VA L U E O F M O N E Y
This chapter went through a major revision aimed at making it more accessible to todays
math-phobic students. Without a sacrifice of rigor or content, the chapter was revised to
eliminate the use of summation signs. In addition, there was a large increase in the use of
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xxvi P R E FA C E

calculator examples. The end-of-chapter problems were also expanded and improved,
allowing for a significant increase in the number of end-of-chapter problems that are
calculator based.

CHAPTER 6 THE MEANING AND MEASUREMENT OF RISK AND RETURN


To make it more relevant and interesting to students, we used a firm they would be familiar
withBarnes & Nobleto illustrate the concepts and computations regarding market risk.

C H A P T E R 7 V A L U AT I O N A N D C H A R A C T E R I S T I C S O F B O N D S
This chapter was updated and revised to reflect changes in the capital markets. Several new
topics, such as convertibility, call provisions, and current yield, were also added.

C H A P T E R 8 V A L U AT I O N A N D C H A R A C T E R I S T I C S O F S T O C K
This chapter was updated and revised to reflect changes in the stock market. In addition,
the presentation of shareholder valuation based on a firms expected future free cash flows
was simplified and clarified.

C H A P T E R 9 C A P I TA L - B U D G E T I N G T E C H N I Q U E S A N D P R A C T I C E
The use of a financial calculator in calculating the different capital-budgeting decision tools
was expanded along with a significant expansion of margin examples on how to use a
financial calculator to calculate the different capital-budgeting criteria. In addition, the
modified internal rate of return (MIRR) was introduced. This capital-budgeting criterion
has become increasingly popular thanks in part to the efforts of the consulting firm
McKinsey & Company. This section can be omitted for those who choose to do so. In
addition, a new Across the Hall box was introduced highlighting the relationship between
marketing and capital budgeting.

C H A P T E R 1 0 C A S H F L O W S A N D O T H E R T O P I C S I N C A P I TA L B U D G E T I N G
The presentation of the calculation of free cash flows was simplified considerably. A new
Across the Hall box was introduced examining the role of marketing in calculating a
projects free cash flows. In addition, the end-of-chapter problem set was expanded.

C H A P T E R 1 1 C O S T O F C A P I TA L
In response to users suggestions, we simplified the discussion of the issues encountered in
using the dividend growth model to estimate the cost of equity capital. Also at the request
of users, we changed notation for equations to reduce the use of mathematical symbols. For
example, the discounted cash flow model used for estimating the cost of debt financing now
uses a three-year bond with all the terms specified. This change is geared toward making
the book more accessible to students with math phobia. In addition, two new weighted
average cost of capital self-test problems were added to help students develop skill in
evaluating the firms cost of capital.

CHAPTER 12 DETERMINING THE FINANCING MIX


This chapter is now rich with actual company examples and discussions on financing
decisions. For instance, financial leverage, operating leverage, and the combined leverage
effect are demonstrated via examples dealing with Harley-Davidson, Inc., Procter &
Gamble Company, and the Boeing Company. Furthermore, General Motors pricing
strategy is discussed within the framework of break-even analysis. And Walt Disneys use of
the interest-coverage ratio is presented.
A new Web Works section deals with General Motors, Coca-Cola, and the Federal
Reserve Bank of St. Louis. The latter source, the St. Louis Fed Web site, introduces the
student to the popular and useful FRED II database; this database is a marvelous site for
financial and economic time series data and is updated daily by the bank.

CHAPTER 13 DIVIDEND POLICY AND INTERNAL FINANCING


New material now centers on the divergent nature of dividend policy across corporations.
Three highly different policies are illustrated via data from Starbucks, Coca-Cola, and
Harley-Davidson. Later in the chapter an in-depth look at Harley-Davidsons cash payout
KEOWMF_i-001-hr 5/20/05 10:40 Page xxvii

P R E FA C E xxvii

policy is examined over the 19972003 time frame and specifically related to Objective 4
of the chapter that details three common and alternative dividend policies.
In similar fashion the unusually large Microsoft dividend payout of $3.00 per common
share (some $32 billion across all shares), which was announced in the summer of 2004, is
discussed within the framework of an extra or special dividend.
Moreover, the implications of the Jobs and Growth Tax Reconciliation Act of 2003 for
corporate dividend policy are presented.

C H A P T E R 1 4 S H O R T- T E R M F I N A N C I A L P L A N N I N G
In addition to updating the material in this chapter, a new financial forecasting exercise was
created that focuses on the projection of a firms earning power. Also, new Internet-based
problems and exercises connect the book to day-to-day activities in the financial markets.

C H A P T E R 1 5 W O R K I N G - C A P I TA L M A N A G E M E N T
A new self-test problem was added aimed at helping students develop the skills necessary
for analyzing the cost of bank credit under a variety of loan covenants. In addition, new
Internet-based problems and exercises connect the book to day-to-day activities in the
financial markets.

CHAPTER 16 CURRENT ASSET MANAGEMENT


This chapter contains several alterations aimed at making the material more relevant to
decision making and more up-to-date, which, in turn, will make it of more value to
students. For example, recent data from Starbucks Corporation and the Walt Disney
Company are used to demonstrate the value and importance of float reduction within the
context of corporate cash management.
The Check Clearing for the 21st Century Act, which went into effect on October 28,
2004, is reviewed and placed within the context of the Treasury Departments mission
within the firm to properly manage the float. The implications of this act, commonly
referred to as Check 21, for the various types of float are discussed.
Additionally, a new Takin It to the Net section introduces the student to the U.S.
Department of the Treasurys comprehensive Web site at www.treasurydirect.gov where
individuals, corporations, and governments can explore detailed information on the array
of investment products offered by the U.S. Treasury.

C H A P T E R 1 7 I N T E R N AT I O N A L F I N A N C I A L M A N A G E M E N T
This chapter was updated to reflect the changes impacting the global financial markets. In
addition, a new Across the Hall box was introduced highlighting the role of marketing in
international finance.

THE SUPPORT PACKAGE

PRINT SUPPLEMENTS:

FOR THE INSTRUCTOR:


T E S T I T E M F I L E This Test Bank, prepared by Alan D. Eastman of Indiana University of
Pennsylvania, provides more than 1,600 multiple-choice, true/false, and short-answer
questions with complete and detailed answers. The print Test Bank is designed for use with
the new TestGen-EQ test generating software.

I N S T R U C T O R S M A N U A L W I T H S O L U T I O N S Prepared by the authors, the


Instructors Manual follows the textbooks organization and represents a continued effort to
serve the teacher in his or her goal of being effective in the classroom. Each chapter con-
tains a chapter orientation, an outline of each chapter (also suitable for lecture notes),
answers to end-of-chapter questions, and an extensive problem set for each chapter, includ-
ing a large number of alternative problems along with answers.
KEOWMF_i-001-hr 5/20/05 10:40 Page xxviii

xxviii P R E FA C E

The Instructors Manual is also available electronically and instructors can download
this file from the Instructors Resource Center by visiting www.prenhall.com/keown.

C O L O R T R A N S P A R E N C I E S All figures and tables from the text are reproduced as


full-page, four-color acetates.

FOR THE S T U D E N T:
S T U D Y G U I D E The Study Guide to accompany Foundations of Finance: The Logic and
Practice of Financial Management, 5th Edition, was written by the authors with the objective
of providing a student-oriented supplement to the text. Each chapter of the Study Guide
contains an orientation of each chapter along with a chapter outline of key topics, problems
(with detailed solutions) and self-tests, which can be used to aid in the preparation of out-
side assignments and in studying for exams, a tutorial on capital budgeting, a set of tables
that not only gives compound sum and present value interest factors but also shows how to
compute the interest using a financial calculator.

TECHNOLOGY SUPPLEMENTS:

C O M P A N I O N W E B S I T E (www.prenhall.com/keown) The Web site contains various


activities related specifically to the Fifth Edition of Foundations of Finance: The Logic and
Practice of Financial Management.

FOR THE S T U D E N T:
Excel Spreadsheets. Created by the authors, these spreadsheets correspond with the
end-of-chapter problems from the text.
Internet Exercises. These activities, prepared by James M. Forjan of York College of
Pennsylvania, give students the opportunity to utilize the tools and information available
on the Internet by directing them to various online sites and then providing a summary
and a set of questions about the experience.
Online Study Guide. The Online Study Guide, prepared by Philip Samuel Russel of
Philadelphia University, offers students another opportunity to sharpen their prob-
lem-solving skills and to assess their understanding of the text material. The Online
Study Guide is a truly comprehensive set of questions with exceptional coverage of
the material in the textbook and written by the authors. The Online Study Guide
grades each question submitted by the students, provides immediate feedback for
correct and incorrect answers, and allows students to e-mail results to up to four
e-mail addresses.

FOR THE INSTRUCTOR:


Syllabus Manager. Allows instructors to create a syllabus that they may publish for
their students to access. Instructors may add exams or assignments of their own, edit any
of the student resources available on the Companion Website, post discussion topics,
and more.
Instructors may find downloadable resources from the link for the Instructors Resource
Center described here.

I N S T R U C T O R S R E S O U R C E C E N T E R This password-protected site is accessible at


www.prenhall.com/keown and hosts all of the resources that follow. Instructors should
click on the Help Downloading Instructor Resources link for easy-to-follow instructions
on getting access or may contact their sales representative for further information.
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Instructors Manual
Solutions to the Internet Exercise activities that are included on the student side of the
Companion Website.
The PowerPoint Lecture Presentation: This lecture presentation tool, prepared by
Samuel A. Veraldi of Duke University, provides the instructor with individual lecture
outlines to accompany the text. The slides include many of the figures and tables from
the text. These lecture notes can be used as is or professors can easily modify them to
reflect specific presentation needs.
TestGen-EQ software: The print Test Item File is designed for use with the
TestGen-EQ test generating software. This computerized package allows instructors to
custom design, save, and generate classroom tests. The test program permits instruc-
tors to edit, add, or delete questions from the test bank; edit existing graphics and cre-
ate new graphics; analyze test results; and organize a database of tests and student
results. This new software allows for greater flexibility and ease of use. It provides many
options for organizing and displaying tests, along with a search and sort feature.

O N E K E Y Available by using one of the access codes shrink-wrapped with the book,
OneKey is Prentice Halls exclusive new resource for instructors and students. OneKey
gives you access to the best online teaching and learning toolsall available 24 hours a day,
7 days a week. OneKey means all your resources are in one place for maximum conve-
nience, simplicity, and success. Instructors have access online, in the course management
system of their choosing, to all available course supplements. Instructors can create and
assign tests, quizzes, or graded homework assignments. OneKey saves instructors time by
grading all questions and tracking results in the online course grade book. Students have
access to interactive exercises, quizzes, useful links, and much more. The following
resources are available:
Study Guide.
Self-Study Quizzes.
Graded Homework Assignments.
PowerPoint Lecture Notes.
Learning Objectives.
Chapter Summaries.
Research Navigator. Your OneKey course gives you direct access to Prentice Halls
powerful online research tool, Research Navigator. Research Navigator is an online aca-
demic research service that helps students learn and master the skills needed to write
effective papers and complete research assignments. Research Navigator includes three
databases of credible and reliable source material.
EBSCOs ContentSelect Academic Journal database gives you instant access to
thousands of academic journals and periodicals. You can search these on-line jour-
nals by keyword, topic, or multiple topics. It also guides students step by step
through the writing of a research paper.
The New York Times Search-by-Subject Archive allows you to search by subject
and by keyword.
Link Library is a collection of links to Web sites, organized by academic subject and
key terms. The links are monitored and updated each week.
Instructor Resource Center.

OneKey for CourseCompass allows instructors to communicate with students,


distribute course material, and access student progress online. For access to this material,
see www.prenhall.com/coursecompass.
OneKey for WebCT provides content and enhanced features to help instructors create
a complete online course. See www.prenhall.com/webct for more information.
Finally, OneKey for Blackboard allows instructors to create online courses using the
Blackboard tools, which include design, communications, testing, and course management
tools. See www.prenhall.com/blackboard for more information.
KEOWMF_i-001-hr 5/20/05 10:40 Page xxx

xxx P R E FA C E

SUBSCRIPTIONS:

Analyzing current events is an important skill for economic students to develop. To sharpen
this skill and further support the books theme of exploration and application, Prentice Hall
offers you and your students three news subscription offers:
The Wall Street Journal Print and Interactive Editions Subscription
Prentice Hall has formed a strategic alliance with the Wall Street Journal, the most
respected and trusted daily source for information on business and economics. For a small
additional charge, Prentice Hall offers your students a 10-week or 15-week subscription to
the Wall Street Journal print edition and the Wall Street Journal Interactive Edition. Upon
adoption of a special package containing the book and the subscription booklet, professors
will receive a free one-year subscription of the print and interactive versions as well as
weekly subject-specific Wall Street Journal educators lesson plans.
The Financial Times
We are pleased to announce a special partnership with the Financial Times. For a small
additional charge, Prentice Hall offers your students a 15-week subscription to the
Financial Times. Upon adoption of a special package containing the book and
the subscription booklet, professors will receive a free one-year subscription. Please contact
your Prentice Hall representative for details and ordering information.
Economist.com
Through a special arrangement with Economist.com, Prentice Hall offers your students a
12-week subscription to Economist.com for a small additional charge. Upon adoption of
a special package containing the book and the subscription booklet, professors will receive a
free six-month subscription. Please contact your Prentice Hall representative for further
details and ordering information.

ACKNOWLEDGMENTS

We gratefully acknowledge the assistance, support, and encouragement of those individuals


who have contributed to Foundations of Finance. Specifically, we wish to recognize the very
helpful insights provided by many of our colleagues. For their careful comments and helpful
reviews of the text, we are indebted to:

Ibrahim J. Affeneh Waldo L. Born


Indiana University of Pennsylvania Eastern Illinois University
Sung C. Bae Joe Brocato
Bowling Green State University Tarleton State University
Laurey Berk Paul Bursik
University of Wisconsin, Green Bay St. Norbert College
Ronald W. Best Soku Byoun
University of South Alabama University of Southern Indiana
Stephen Black Anthony K. Byrd
University of Central Oklahoma University of Central Florida
Laurence E. Blose P. R. Chandy
University of North Carolina, Charlotte University of North Texas
Robert Boldin Santosh Choudhury
Indiana University of Pennsylvania Norfolk State University
Michael Bond K. C. Chen
Cleveland State University California State University, Fresno
KEOWMF_i-001-hr 5/20/05 10:40 Page xxxi

P R E FA C E xxxi

Jeffrey S. Christensen Ravi Kamath


Youngstown State University Cleveland State University
M. C. Chung James D. Keys
California State University, Sacramento Florida International University
Susan Coleman V. Sivarama Krishnan
University of Hartford Cameron University
Steven M. Dawson Reinhold P. Lamb
University of Hawaii University of North Carolina Charlotte
Karen Denning Larry Lang
Western Virginia University University of Wisconsin
Yashwant S. Dhatt George B. F. Lanigan
University of Southern Colorado University of North Carolina, Greensboro
Thomas Downs Stephen Larson
University of Alabama University of Eastern Illinois
Edwin Duett William R. Lasher
Mississippi State University Nichols College
John W. Ellis David E. Letourneau
Colorado State University Winthrop University
Suzanne Erickson Ilene Levin
Seattle University University of MinnesotaDuluth
Slim Feriani David Louton
George Washington University Bryant College
Greg Filbeck Lee McClain
Miami University Western Washington University
Jennifer Frazier Ginette M. McManus
James Madison University St. Josephs University
Bruce Fredrikson Michael McMillan
Syracuse University Northern Virginia Community College
Joseph F. Greco James E. McNulty
California State University, Fullerton Florida Atlantic University
Karen Hallows Grant McQueen
George Mason University Brigham Young University
Ken Halsey Judy E. Maese
Wayne State College New Mexico State University
Mary H. Harris Abbas Mamoozadeh
Cabrini College Slippery Rock University
James D. Harriss Emil Meurer
University of North Carolina, Wilmington University of New Orleans
Linda C. Hittle Stuart Michelson
San Diego State University Eastern Illinois University
Robert Hull Eric J. Moon
Washburn University San Francisco State University
Joel Jankowski Scott Moore
University of Tampa John Carroll University
Gerry Jensen Diane Morrison
Northern Illinois University University of Wisconsin at LaCrosse
Steve Johnson Rick H. Mull
University of Texas at El Paso Fort Lewis College
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xxxii P R E FA C E

M. P. Narayanan Elizabeth Sun


University of Michigan San Jose State University
William E. OConnell Jr. R. Bruce Swensen
College of William & Mary Adelphi University
Thomas M. Patrick Philip R. Swensen
The College of New Jersey Utah State University
Samuel Penkar Lee Tenpao
University of HoustonDowntown Niagara University
Jeffrey H. Peterson Philip Thames
St. Bonaventure University California State University at Long Beach
Mario Picconi Paul A. Vanderheiden
University of San Diego University of Wisconsin, Eau Claire
Chris Pope Nikhil P. Varaiya
University of Georgia San Diego State University
Pradipkumar Ramanlal K. G. Viswanathan
University of Central Florida Hofstra University
P. Raghavendra Rau Al Webster
Purdue University Bradley University
Dan Reeder Patricia Webster
Oklahoma Baptist University Bradley University
Stuart Rosenstein Herbert Weinraub
Clemson University University of Toledo
Ivan C. Roten Sandra Williams
Arizona State University Moorhead State University
Marjorie A. Rubash Tony R. Wingler
Bradley University University of North Carolina, Greensboro
Atul K. Saxena Bob G. Wood, Jr.
Mercer University Tennessee Tech University
Hari P. Sharma Jian Yang
Virginia State University Prairie View A & M University
Chi Sheh Ata Yesilyaprak
University of Houston Columbus State University
Joseph Stanford Wold Zernedkun
Bridgewater State College Norfolk State University
David Suk Marc Zenner
Rider University Indiana University
Charlene Sullivan
Purdue University
KEOWMF_i-001-hr 5/20/05 11:34 Page 1

P R E FA C E 1

We also thank our friends at Prentice Hall. They are a great group of folks. To David
Alexander, our executive editor, we owe an immeasurable debt of gratitude. He continued
to push us to make sure that we delivered the finest textbook and supplementary package
possible. His efforts go well beyond what one might expect from the best of editors. On top
of this, David is just a great personthanks, David. We would also like to thank Francesca
Calogero for her administrative deftness. Not only is she bright, insightful, and attentive to
detailin short, a gifted assistant editorbut she also made the revision a fun experience.
She is a true friend. With Francesca watching over us, there was no way the ball could be
dropped. Our thanks also go to Sharon Koch for her marketing prowess. Sharon has an
amazing understanding of the market, coupled with an intuitive understanding of what the
market is looking for. We also thank Nancy Welcher, our media manager, who did a great
job of making sure we are on the cutting edge in terms of Web applications and offerings.
To Denise Culhane, the production editor, we express a very special thank-you for seeing
the book through a very complex production process and keeping it all on schedule while
maintaining extremely high quality.
As a final word, we express our sincere thanks to those using Foundations of Finance in
the classroom. We thank you for making us a part of your team. Always feel free to give any
of us a call or contact us through the Internet when you have questions or needs.

A.J.K. / J.D.M. / J.W.P. / D.F.S.