Eugene F. Brigham 2c Michael C. Ehrhardt
FREQUENTLY USED SYMBOLS
ACP
ADR
APR
AR
b
bL
bU
BEP
BVPS
CAPM
CCC
CF
CFPS
CR
CV
Δ
Dps
Dt
DCF
D/E
DPS
DRIP
DRP
DSO
EAR
EBIT
EBITDA
EPS
EVA
F
FCF
FVN
FVAN
g
I
I/YR
INT
IP
IPO
IRR
LP
M
M/B
MIRR
MRP
MVA
n
N
N(di)
NOPAT
NOWC
NPV
P
Pc
Average collection period
American Depository Receipt
Annual percentage rate
Accounts receivable
Beta coefficient, a measure of an asset’s market risk
Levered beta
Unlevered beta
Basic earning power
Book value per share
Capital Asset Pricing Model
Cash conversion cycle
Cash flow; CFt is the cash flow in Period t
Cash flow per share
Conversion ratio
Coefficient of variation
Difference, or change (uppercase delta)
Dividend of preferred stock
Dividend in Period t
Discounted cash flow
Debt-to-equity ratio
Dividends per share
Dividend reinvestment plan
Default risk premium
Days sales outstanding
Effective annual rate, EFF%
Earnings before interest and taxes; net operating income
Earnings before interest, taxes, depreciation, and amortization
Earnings per share
Economic Value Added
(1) Fixed operating costs
(2) Flotation cost
Free cash flow
Future value for Year N
Future value of an annuity for N years
Growth rate in earnings, dividends, and stock prices
Interest rate; also denoted by r
Interest rate key on some calculators
Interest payment in dollars
Inflation premium
Initial public offering
Internal rate of return
Liquidity premium
(1) Maturity value of a bond
(2) Margin (profit margin)
Market-to-book ratio
Modified Internal Rate of Return
Maturity risk premium
Market Value Added
Number of shares outstanding
Calculator key denoting number of periods
Represents area under a standard normal distribution function
Net operating profit after taxes
Net operating working capital
Net present value
(1) Price of a share of stock in Period t; P0 = price of the stock today
(2) Sales price per unit of product sold
Conversion price
Pf
Ph
PN
P/E
PMT
PPP
PV
PVAN
Q
QBE
r
¯r
^r
r*
rd
re
rf
rh
ri
rM
rNOM
rps
rPER
rRF
rs
ρ
ROA
ROE
RP
RPM
RR
S
SML
∑
σ
σ2
t
T
TVN
TIE
V
VB
VL
Vop
Vps
VU
VC
w
wd
wps
ws
wce
WACC
X
YTC
YTM
Price of good in foreign country
Price of good in home country
A stock’s horizon, or terminal, value
Price/earnings ratio
Payment of an annuity
Purchasing power parity
Present value
Present value of an annuity for N years
Quantity produced or sold
Breakeven quantity
(1) A percentage discount rate, or cost of capital; also denoted by i
(2) Nominal risk-adjusted required rate of return
“r bar,” historic, or realized, rate of return
“r hat,” an expected rate of return
Real risk-free rate of return
Before-tax cost of debt
Cost of new common stock (outside equity)
Interest rate in foreign country
Interest rate in home country
Required return for an individual firm or security
Return for “the market” or for an “average” stock
Nominal rate of interest; also denoted by iNOM
(1) Cost of preferred stock
(2) Portfolio’s return
Periodic rate of return
Rate of return on a risk-free security
(1) Required return on common stock
(2) Cost of old common stock (inside equity)
Correlation coefficient (lowercase rho); also denoted by R when using historical data
Return on assets
Return on equity
Risk premium
Market risk premium
Retention rate
(1) Sales
(2) Estimated standard deviation for sample data
(3) Intrinsic value of stock (i.e., all common equity)
Security Market Line
Summation sign (uppercase sigma)
Standard deviation (lowercase sigma)
Variance
Time period
Marginal income tax rate
A stock’s horizon, or terminal, value
Times interest earned
Variable cost per unit
Bond value
Total market value of a levered firm
Value of operations
Value of preferred stock
Total market value of an unlevered firm
Total variable costs
Proportion or weight
Weight of debt
Weight of preferred stock
Weight of common equity raised internally by retaining earnings
Weight of common equity raised externally by issuing stock
Weighted averaged cost of capital
Exercise price of option
Yield to call
Yield to maturity
Financial Management:
Theory and Practice
THIRTEENTH EDITION
MICHAEL C. EHRHARDT
University of Tennessee
EUGENE F. BRIGHAM
University of Florida
Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States
Financial Management: Theory and Practice,
Thirteen Edition
Michael C. Ehrhardt and Eugene F. Brigham
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1 2 3 4 5 6 7 14 13 12 11 10
Brief Contents
Preface
PART 1
xix
Fundamental Concepts
1
of Corporate Finance
CHAPTER 1 An Overview of Financial
Management and the Financial
Environment 3
Web Extensions
PART 3
Web Extensions
1B: A Closer Look at the Stock
Markets
Web Extensions
2A: The Federal Income Tax
System for Individuals
CHAPTER 3 Analysis of Financial
Statements 87
PART 2
123
CHAPTER 7 Stocks, Stock Valuation,
and Stock Market
Equilibrium 267
7A: Derivation of Valuation
Equations
CHAPTER 8 Financial Options and Applications
in Corporate Finance 305
Web Extensions
PART 4
4A: The Tabular Approach
4B: Derivation of Annuity Formulas
4C: Continuous Compounding
CHAPTER 5 Bonds, Bond Valuation, and
Interest Rates 173
Web Extensions
6A: Continuous Probability
Distributions
6B: Estimating Beta with
a Financial Calculator
Fixed Income
Securities 121
CHAPTER 4 Time Value of Money
Web Extensions
215
CHAPTER 6 Risk, Return, and the Capital
Asset Pricing Model 217
1A: An Overview of Derivatives
CHAPTER 2 Financial Statements, Cash Flow,
and Taxes 47
Stocks and Options
5A: A Closer Look at Zero
Coupon Bonds
5B: A Closer Look at TIPS:
Treasury Inflation-Protected
Securities
5C: A Closer Look at Bond Risk:
Duration
5D: The Pure Expectations Theory
and Estimation of Forward Rates
Projects and Their
Valuation 333
CHAPTER 9 The Cost of Capital
335
9A: The Required Return
Assuming Nonconstant Dividends
and Stock Repurchases
CHAPTER 10 The Basics of Capital Budgeting:
Evaluating Cash Flows 379
Web Extensions
10A: The Accounting Rate of
Return (ARR)
CHAPTER 11 Cash Flow Estimation and Risk
Analysis 423
Web Extensions
Web Extensions
11A: Certainty Equivalents
and Risk-Adjusted Discount
Rates
iii
iv
Brief Contents
PART 5
Corporate Valuation
and Governance 471
CHAPTER 12 Financial Planning and
Forecasting Financial
Statements 473
12A: Advanced Techniques for
Forecasting Financial Statements
Accounts
CHAPTER 13 Corporate Valuation,
Value-Based Management
and Corporate Governance 511
Web Extensions
PART 6
Cash Distributions and
Capital Structure 557
CHAPTER 14 Distributions to Shareholders:
Dividends and Repurchases 559
CHAPTER 15 Capital Structure
Decisions 599
Web Extensions
15A: Degree of Leverage
PART 7
Managing Global
Operations 639
CHAPTER 16 Working Capital
Management 641
16A: Secured Short-Term
Financing
CHAPTER 17 Multinational Financial
Management 691
CHAPTER 19 Hybrid Financing: Preferred
Stock, Warrants, and
Convertibles 759
Web Extensions
19A: Calling Convertible
Issues
CHAPTER 20 Initial Public Offerings,
Investment Banking,
and Financial
Restructuring 787
Web Extensions
20A: Rights Offerings
PART 9
Special Topics
825
CHAPTER 21 Mergers, LBOs, Divestitures, and
Holding Companies 827
Web Extensions
21A: Projecting Consistent Debt
and Interest Expenses
CHAPTER 22 Bankruptcy, Reorganization, and
Liquidation 869
Web Extensions
22A: Multiple Discriminant
Analysis
CHAPTER 23 Derivatives and Risk
Management 899
Web Extensions
23A: Risk Management with
Insurance
Web Extensions
PART 8
Tactical Financing
Decisions 731
CHAPTER 18 Lease Financing
Web Extensions
733
18A: Leasing Feedback
18B: Percentage Cost Analysis
18C: Leveraged Leases
PART 10
Advanced Issues
929
CHAPTER 24 Portfolio Theory, Asset Pricing
Models, and Behavioral
Finance 931
CHAPTER 25 Real Options
Web Extensions
971
25A: The Abandonment Real
Option
25B: Risk-Neutral Valuation
CHAPTER 26 Analysis of Capital Structure
Theory 995
Brief Contents
Appendixes
Appendix A Solutions to Self-Test
Problems 1029
Appendix B Answers to End-of-Chapter
Problems 1063
Appendix C Selected Equations and
Data 1071
Appendix D Values of the Areas under the
Standard Normal Distribution
Function 1085
Glossary 1087
Name Index 1113
Subject Index 1119
Web Chapters
CHAPTER 27 Providing and Obtaining Credit
CHAPTER 28 Advanced Issues in Cash
Management and Inventory
Control
CHAPTER 29 Pension Plan Management
CHAPTER 30 Financial Management in
Not-for-Profit Businesses
v
Contents
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xix
PART 1 Fundamental Concepts of Corporate Finance 1
CHAPTER 1
An Overview of Financial Management and the Financial Environment
The Five-Minute MBA
4
5
Box: Say Hello to the Global Economic Crisis!
The Corporate Life Cycle
5
Box: Columbus Was Wrong—the World Is Flat! And Hot, and Crowded!
The Primary Objective of the Corporation: Value Maximization
Box: Ethics for Individuals and Businesses
10
Box: Corporate Scandals and Maximizing Stock Price 13
An Overview of the Capital Allocation Process
Financial Securities
15
The Cost of Money
19
Financial Institutions
Financial Markets
23
27
Trading Procedures in Financial Markets
Types of Stock Market Transactions
Box: Rational Exuberance?
Box: Measuring the Market
Stock Market Returns
Summary
31
33
34
The Global Economic Crisis
e-Resources
29
30
31
The Secondary Stock Markets
The Big Picture
13
36
42
43
44
Web Extensions
1A: An Overview of Derivatives
1B: A Closer Look at the Stock Markets
CHAPTER 2
Financial Statements, Cash Flow, and Taxes
47
Box: Intrinsic Value, Free Cash Flow, and Financial Statements
Financial Statements and Reports
The Balance Sheet
49
Box: Let’s Play Hide-and-Seek!
vi
51
48
48
9
6
3
Contents
The Income Statement
52
Statement of Stockholders’ Equity
Net Cash Flow
53
54
Statement of Cash Flows
55
Box: Financial Analysis on the WEB 56
Modifying Accounting Data for Managerial Decisions
MVA and EVA
67
Box: Sarbanes-Oxley and Financial Fraud
The Federal Income Tax System
Summary
59
63
Box: Financial Bamboozling: How to Spot It
70
71
76
Web Extensions
2A: The Federal Income Tax System for Individuals
CHAPTER 3
Analysis of Financial Statements
87
88
Box: Intrinsic Value and Analysis of Financial Statements
Financial Analysis
88
Liquidity Ratios
89
Asset Management Ratios
92
Box: The Price is Right! (Or Wrong!)
Debt Management Ratios
Profitability Ratios
93
95
98
Box: The World Might be Flat, but Global Accounting is Bumpy!
The Case of IFRS versus FASB 99
Market Value Ratios
100
Trend Analysis, Common Size Analysis, and Percentage Change Analysis
Tying the Ratios Together: The Du Pont Equation
Comparative Ratios and Benchmarking
107
Uses and Limitations of Ratio Analysis
108
Box: Ratio Analysis on the Web
Looking beyond the Numbers
Summary
106
109
110
110
PART 2 Fixed Income Securities 121
CHAPTER 4
Time Value of Money
123
Box: Corporate Valuation and the Time Value of Money 124
Time Lines
125
Future Values
125
Box: Hints on Using Financial Calculators
129
Box: The Power of Compound Interest 132
Present Values
133
102
vii
viii
Contents
Finding the Interest Rate, I
136
Finding the Number of Years, N
Annuities
137
138
Future Value of an Ordinary Annuity
Future Value of an Annuity Due
138
141
Present Value of Ordinary Annuities and Annuities Due
Finding Annuity Payments, Periods, and Interest Rates
Perpetuities
141
144
Box: Variable Annuities: Good or Bad?
144
146
Box: Using the Internet for Personal Financial Planning
Uneven, or Irregular, Cash Flows
147
148
Future Value of an Uneven Cash Flow Stream
Solving for I with Irregular Cash Flows
151
152
Semiannual and Other Compounding Periods
153
Box: Truth in Lending: What Loans Really Cost 156
Fractional Time Periods
Amortized Loans
157
158
Growing Annuities
159
Box: An Accident Waiting to Happen: Option Reset
Adjustable Rate Mortgages 160
Summary
162
Web Extensions
4A: The Tabular Approach
4B: Derivation of Annuity Formulas
4C: Continuous Compounding
CHAPTER 5
Bonds, Bond Valuation, and Interest Rates
Box: Intrinsic Value and the Cost of Debt
Who Issues Bonds?
173
174
174
Key Characteristics of Bonds
175
Box: Betting With or Against the U.S. Government:
The Case of Treasury Bond Credit Default Swaps 176
Bond Valuation
180
Changes in Bond Values over Time
Box: Drinking Your Coupons
Bonds with Semiannual Coupons
Bond Yields
184
187
187
188
The Pre-Tax Cost of Debt: Determinants of Market Interest Rates
The Real Risk-Free Rate of Interest, r*
The Inflation Premium (IP)
192
193
The Nominal, or Quoted, Risk-Free Rate of Interest, rRF
The Default Risk Premium (DRP)
195
195
Box: Insuring with Credit Default Swaps: Let the Buyer Beware!
197
191
Contents
Box: Might the U.S. Treasury Bond Be Downgraded?
Box: Are Investors Rational?
201
The Maturity Risk Premium (MRP)
201
The Term Structure of Interest Rates
204
205
Bankruptcy and Reorganization
Summary
199
201
The Liquidity Premium (LP)
Financing with Junk Bonds
ix
206
207
Web Extensions
5A: A Closer Look at Zero Coupon Bonds
5B: A Closer Look at TIPS: Treasury Inflation-Protected Securities
5C: A Closer Look at Bond Risk: Duration
5D: The Pure Expectations Theory and Estimation of Forward Rates
PART 3 Stocks and Options 215
CHAPTER 6
Risk, Return, and the Capital Asset Pricing Model
Box: Intrinsic Value, Risk, and Return
Returns on Investments
Stand-Alone Risk
217
219
219
220
Box: What Does Risk Really Mean?
227
229
Box: The Trade-off between Risk and Return
Risk in a Portfolio Context
231
236
Box: How Risky Is a Large Portfolio of Stocks?
Box: The Benefits of Diversifying Overseas
Calculating Beta Coefficients
239
243
The Relationship between Risk and Return
246
Box: Another Kind of Risk: The Bernie Madoff Story
Some Concerns about Beta and the CAPM
252
253
Some Concluding Thoughts: Implications for Corporate Managers and Investors
Summary
255
Web Extensions
6A: Continuous Probability Distributions
6B: Estimating Beta with a Financial Calculator
CHAPTER 7
Stocks, Stock Valuation, and Stock Market Equilibrium
Box: Corporate Valuation and Stock Prices
268
Legal Rights and Privileges of Common Stockholders
Types of Common Stock
269
The Market Stock Price versus Intrinsic Value
Stock Market Reporting
272
270
268
267
253
x
Contents
Valuing Common Stocks
273
Valuing a Constant Growth Stock
276
Expected Rate of Return on a Constant Growth Stock
Valuing Nonconstant Growth Stocks
281
Stock Valuation by the Free Cash Flow Approach
Market Multiple Analysis
Preferred Stock
279
285
285
286
Stock Market Equilibrium
287
The Efficient Markets Hypothesis
290
Box: Rational Behavior versus Animal Spirits, Herding, and Anchoring Bias 293
Summary
294
Web Extensions
7A: Derivation of Valuation Equations
CHAPTER 8
Financial Options and Applications in Corporate Finance
Box: The Intrinsic Value of Stock Options
Overview of Financial Options
306
306
309
Box: Financial Reporting for Employee Stock Options
The Single-Period Binomial Option Pricing Approach
310
The Single-Period Binomial Option Pricing Formula
The Multi-Period Binomial Option Pricing Model
The Black-Scholes Option Pricing Model (OPM)
Box: Taxes and Stock Options
The Valuation of Put Options
314
316
319
324
325
Applications of Option Pricing in Corporate Finance
Summary
305
326
328
PART 4 Projects and Their Valuation 333
CHAPTER 9
The Cost of Capital
335
Box: Corporate Valuation and the Cost of Capital
The Weighted Average Cost of Capital
Basic Definitions
336
337
338
Cost of Debt, rd(1 − T)
340
Cost of Preferred Stock, rps
342
Box: GE and Warren Buffett: The Cost of Preferred Stock
Cost of Common Stock, rs
The CAPM Approach
343
344
345
Dividend-Yield-Plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach
Over-Own-Bond-Yield-Plus-Judgmental-Risk-Premium Approach
353
355
Comparison of the CAPM, DCF, and Over-Own-Bond-Yield-Plus-Judgmental-RiskPremium Methods 356
Contents
Adjusting the Cost of Equity for Flotation Costs
357
Composite, or Weighted Average, Cost of Capital, WACC
358
Box: Global Variations in the Cost of Capital 361
Factors That Affect the WACC
361
Adjusting the Cost of Capital for Risk
363
Privately Owned Firms and Small Businesses
Four Mistakes to Avoid
Summary
366
367
368
Web Extensions
9A: The Required Return Assuming Nonconstant Dividends and Stock Repurchases
CHAPTER 10
The Basics of Capital Budgeting: Evaluating Cash Flows
381
Box: Corporate Valuation and Capital Budgeting
An Overview of Capital Budgeting
Net Present Value (NPV)
381
383
Internal Rate of Return (IRR)
387
Box: Why NPV Is Better Than IRR
Multiple Internal Rates of Return
Reinvestment Rate Assumptions
389
390
392
Modified Internal Rate of Return (MIRR)
NPV Profiles
396
Profitability Index (PI)
Payback Period
400
401
Conclusions on Capital Budgeting Methods
Decision Criteria Used in Practice
405
Other Issues in Capital Budgeting
405
Summary
393
403
411
Web Extensions
10A: The Accounting Rate of Return (ARR)
CHAPTER 11
Cash Flow Estimation and Risk Analysis
423
Box: Corporate Valuation, Cash Flows, and Risk Analysis
Conceptual Issues
424
Analysis of an Expansion Project
Risk Analysis in Capital Budgeting
Measuring Stand-Alone Risk
Sensitivity Analysis
Scenario Analysis
424
429
435
436
436
439
Monte Carlo Simulation
442
Box: Are Bank Stress Tests Stressful Enough? 445
Project Risk Conclusions
446
Box: Capital Budgeting Practices in the Asian/Pacific Region
447
379
xi
xii
Contents
Replacement Analysis 448
Real Options 449
Phased Decisions and Decision Trees
451
Summary 454
Appendix 11A Tax Depreciation 468
Web Extensions
11A: Certainty Equivalents and Risk-Adjusted Discount Rates
PART 5 Corporate Valuation and Governance 471
CHAPTER 12
Financial Planning and Forecasting Financial Statements
Box: Corporate Valuation and Financial Planning
Overview of Financial Planning 474
Sales Forecast 476
Additional Funds Needed (AFN) Method
473
474
478
Forecasted Financial Statements Method 482
Forecasting When the Ratios Change 496
Summary
499
Web Extensions
12A: Advanced Techniques for Forecasting Financial Statements Accounts
CHAPTER 13
Corporate Valuation, Value-Based Management and Corporate
Governance 511
Box: Corporate Valuation: Putting the Pieces Together
Overview of Corporate Valuation
The Corporate Valuation Model
Value-Based Management
513
514
521
Managerial Behavior and Shareholder Wealth
Corporate Governance
512
530
531
Box: Let’s Go to Miami! IBM’s 2009 Annual Meeting 533
Box: Would the U.S. Government Be an Effective Board Director?
Box: Shareholder Reactions to the Crisis
538
Box: The Sarbanes-Oxley Act of 2002 and Corporate Governance
Box: International Corporate Governance
540
542
Employee Stock Ownership Plans (ESOPs)
Summary
536
543
546
PART 6 Cash Distributions and Capital Structure 557
CHAPTER 14
Distributions to Shareholders: Dividends and Repurchases
Box: Uses of Free Cash Flow: Distributions to Shareholders
An Overview of Cash Distributions
560
560
559
Contents
Procedures for Cash Distributions
562
Cash Distributions and Firm Value
Clientele Effect
564
567
Information Content, or Signaling, Hypothesis
Implications for Dividend Stability
568
569
Box: Will Dividends Ever Be the Same?
570
Setting the Target Distribution Level: The Residual Distribution Model
The Residual Distribution Model in Practice
572
A Tale of Two Cash Distributions: Dividends versus Stock Repurchases
The Pros and Cons of Dividends and Repurchases
Box: Dividend Yields around the World 584
Other Factors Influencing Distributions 584
Summarizing the Distribution Policy Decision
Stock Splits and Stock Dividends 587
Dividend Reinvestment Plans
Summary
585
590
591
CHAPTER 15
Capital Structure Decisions
599
Box: Corporate Valuation and Capital Structure
A Preview of Capital Structure Issues
Business Risk and Financial Risk
Capital Structure Theory
600
609
611
Capital Structure Evidence and Implications
618
Box: Taking a Look at Global Capital Structures
Estimating the Optimal Capital Structure
Anatomy of a Recapitalization
Box: Deleveraging
600
603
Box: Yogi Berra on the MM Proposition
Summary
582
588
Box: Talk about a Split Personality!
620
621
625
630
630
Web Extensions
15A: Degree of Leverage
PART 7 Managing Global Operations 639
CHAPTER 16
Working Capital Management
641
Box: Corporate Valuation and Working Capital Management
Current Asset Holdings
The Cash Conversion Cycle
644
648
Box: Some Firms Operate with Negative Working Capital!
The Cash Budget
654
642
643
Current Assets Financing Policies
570
653
573
xiii
xiv
Contents
Cash Management and the Target Cash Balance
658
Box: The CFO Cash Management Scorecard
Cash Management Techniques
Inventory Management
659
661
662
Box: Supply Chain Management
Receivables Management
663
665
Box: Supply Chain Finance
Accruals and Accounts Payable (Trade Credit)
Short-Term Marketable Securities
Short-Term Financing
670
672
676
Use of Security in Short-Term Financing
Summary
667
672
Short-Term Bank Loans
Commercial Paper
657
677
678
Web Extensions
16A: Secured Short-Term Financing
CHAPTER 17
Multinational Financial Management
691
Box: Corporate Valuation in a Global Context 692
Multinational, or Global, Corporations
692
Multinational versus Domestic Financial Management
Exchange Rates
693
694
Exchange Rates and International Trade
698
The International Monetary System and Exchange Rate Policies
Trading in Foreign Exchange
Interest Rate Parity
703
704
Purchasing Power Parity
706
708
Box: Hungry for a Big Mac? Go To Malaysia!
Inflation, Interest Rates, and Exchange Rates
International Money and Capital Markets
709
710
Box: Greasing the Wheels of International Business
Box: Stock Market Indices around the World
Multinational Capital Budgeting
Box: Consumer Finance in China
International Capital Structures
713
714
715
718
Multinational Working Capital Management
Summary
711
720
723
PART 8 Tactical Financing Decisions 731
CHAPTER 18
Lease Financing
Types of Leases
733
734
699
Contents
Tax Effects
736
Financial Statement Effects
738
Box: Off–Balance Sheet Financing: Is It Going to Disappear?
Evaluation by the Lessee
740
Evaluation by the Lessor
745
Other Issues in Lease Analysis
747
Box: What You Don’t Know Can Hurt You!
748
750
Box: Lease Securitization
Other Reasons for Leasing
Summary
740
751
753
Web Extensions
18A: Leasing Feedback
18B: Percentage Cost Analysis
18C: Leveraged Leases
CHAPTER 19
Hybrid Financing: Preferred Stock, Warrants, and Convertibles
Preferred Stock
761
Box: The Romance Had No Chemistry, But It Had a Lot of Preferred Stock!
Warrants
762
765
Convertible Securities
770
A Final Comparison of Warrants and Convertibles
777
Reporting Earnings When Warrants or Convertibles Are Outstanding
Summary
759
778
779
Web Extensions
19A: Calling Convertible Issues
CHAPTER 20
Initial Public Offerings, Investment Banking, and Financial
Restructuring 787
The Financial Life Cycle of a Start-up Company
The Decision to Go Public
788
789
The Process of Going Public: An Initial Public Offering
Equity Carve-outs: A Special Type of IPO
791
799
Other Ways to Raise Funds in the Capital Markets
Box: Bowie Bonds Ch-Ch-Change Asset Securitization
800
803
Investment Banking Activities and Their Role in the Global Economic Crisis
Box: Investment Banks and the Global Economic Crisis
The Decision to Go Private
806
Managing the Maturity Structure of Debt
Refunding Operations
805
808
810
Box: TVA Ratchets Down Its Interest Expenses
813
Managing the Risk Structure of Debt with Project Financing
Summary
817
Web Extensions
20A: Rights Offerings
815
803
xv
xvi
Contents
PART 9 Special Topics 825
CHAPTER 21
Mergers, LBOs, Divestitures, and Holding Companies
Rationale for Mergers
Types of Mergers
827
828
830
Level of Merger Activity
831
Hostile versus Friendly Takeovers
Merger Regulation
832
833
Overview of Merger Analysis
834
The Adjusted Present Value (APV) Approach
835
The Free Cash Flow to Equity (FCFE) Approach
838
Illustration of the Three Valuation Approaches for a Constant Capital Structure
Setting the Bid Price
845
Analysis When There Is a Permanent Change in Capital Structure
Taxes and the Structure of the Takeover Bid
850
Box: Tempest in a Teapot?
Financial Reporting for Mergers
852
Analysis for a “True Consolidation”
The Role of Investment Bankers
Corporate Alliances
Leveraged Buyouts
Divestitures
857
858
858
859
859
Holding Companies
Summary
855
855
Who Wins: The Empirical Evidence
Box: Merger Mistakes
849
860
862
Web Extensions
21A: Projecting Consistent Debt and Interest Expenses
CHAPTER 22
Bankruptcy, Reorganization, and Liquidation
Financial Distress and Its Consequences
869
870
Issues Facing a Firm in Financial Distress
871
Settlements without Going through Formal Bankruptcy
Federal Bankruptcy Law
874
Reorganization in Bankruptcy
Liquidation in Bankruptcy
Box: A Nation of Defaulters?
875
885
888
Other Motivations for Bankruptcy
Some Criticisms of Bankruptcy Laws
Summary
890
Web Extensions
22A: Multiple Discriminant Analysis
889
889
872
847
840
Contents
CHAPTER 23
Derivatives and Risk Management
899
900
Box: Corporate Valuation and Risk Management
Reasons to Manage Risk
901
Background on Derivatives
Derivatives in the News
903
904
Other Types of Derivatives
907
Corporate Risk Management
913
Box: Enterprise Risk Management and Value at Risk
Using Derivatives to Reduce Risks
917
Box: Risk Management in the Cyber Economy
Summary
916
920
924
Web Extensions
23A: Risk Management with Insurance
PART 10 Advanced Issues 929
CHAPTER 24
Portfolio Theory, Asset Pricing Models, and Behavioral Finance
932
Box: Corporate Valuation and Risk
Efficient Portfolios
932
Choosing the Optimal Portfolio
936
The Basic Assumptions of the Capital Asset Pricing Model
The Capital Market Line and the Security Market Line
Calculating Beta Coefficients
Box: Skill or Luck?
939
940
944
945
Empirical Tests of the CAPM
Arbitrage Pricing Theory
952
954
The Fama-French Three-Factor Model
957
An Alternative Theory of Risk and Return: Behavioral Finance
Summary
963
CHAPTER 25
Real Options 971
Valuing Real Options
972
The Investment Timing Option: An Illustration
The Growth Option: An Illustration
Concluding Thoughts on Real Options
Summary
989
Web Extensions
25A: The Abandonment Real Option
25B: Risk-Neutral Valuation
982
986
973
961
931
xvii
xviii
Contents
CHAPTER 26
Analysis of Capital Structure Theory
995
Box: Corporate Valuation and Capital Structure Decisions
996
Capital Structure Theory: Arbitrage Proofs of the Modigliani-Miller Models
Introducing Personal Taxes: The Miller Model
Criticisms of the MM and Miller Models
1010
An Extension of the MM Model: Nonzero Growth and a Risky Tax Shield
Risky Debt and Equity as an Option
1015
Capital Structure Theory: Our View
1019
Summary
996
1006
1011
1021
Appendix
Appendix
Appendix
Appendix
A Solutions to Self-Test Problems . . . . . . . . . . . . . . . . . . . . . . . . . . 1029
B Answers to End-of-Chapter Problems . . . . . . . . . . . . . . . . . . . . . 1063
C Selected Equations and Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1071
D Values of the Areas under the Standard Normal
Distribution Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1085
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1087
Name Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1113
Subject Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1119
WEB CHAPTERS
CHAPTER 27
Providing and Obtaining Credit
CHAPTER 28
Advanced Issues in Cash Management and Inventory Control
CHAPTER 29
Pension Plan Management
CHAPTER 30
Financial Management in Not-for-Profit Businesses
Preface
resource
Be sure to visit the
Financial Management:
Theory and Practice
(13th Edition) Web site at
www.cengage.com/
brigham. This site
provides access for
instructors and students.
When we wrote the first edition of Financial Management: Theory and Practice, we had
four goals: (1) to create a text that would help students make better financial decisions;
(2) to provide a book that could be used in the introductory MBA course, but one that
was complete enough for use as a reference text in follow-on case courses and after
graduation; (3) to motivate students by demonstrating that finance is both interesting
and relevant; and (4) to make the book clear enough so that students could go through
the material without wasting either their time or their professor’s time trying to figure
out what we were saying.
The collapse of the sub-prime mortgage market, the financial crisis, and the global
economic crisis make it more important than ever for students and managers to
understand the role that finance plays in a global economy, in their own companies,
and in their own lives. So in addition to the four goals listed above, this edition has a
fifth goal, to prepare students for a changed world.
INTRINSIC VALUATION
AS A
UNIFYING THEME
Our emphasis throughout the book is on the actions that a manager can and should take
to increase the intrinsic value of the firm. Structuring the book around intrinsic valuation
enhances continuity and helps students see how various topics are related to one another.
As its title indicates, this book combines theory and practical applications. An
understanding of finance theory is absolutely essential for anyone developing and/or
implementing effective financial strategies. But theory alone isn’t sufficient, so we
provide numerous examples in the book and the accompanying Excel spreadsheets to
illustrate how theory is applied in practice. Indeed, we believe that the ability to analyze financial problems using Excel is absolutely essential for a student’s successful job
search and subsequent career. Therefore, many exhibits in the book come directly
from the accompanying Excel spreadsheets. Many of the spreadsheets also provide
brief “tutorials” by way of detailed comments on Excel features that we have found to
be especially useful, such as Goal Seek, Tables, and many financial functions.
The book begins with fundamental concepts, including background on the economic and financial environment, financial statements (with an emphasis on cash
flows), the time value of money, bond valuation, risk analysis, and stock valuation.
With this background, we go on to discuss how specific techniques and decision rules
can be used to help maximize the value of the firm. This organization provides four
important advantages:
1. Managers should try to maximize the intrinsic value of a firm, which is determined
by cash flows as revealed in financial statements. Our early coverage of financial
statements thus helps students see how particular financial decisions affect the various parts of the firm and the resulting cash flow. Also, financial statement analysis
provides an excellent vehicle for illustrating the usefulness of spreadsheets.
2. Covering time value of money early helps students see how and why expected
future cash flows determine the value of the firm. Also, it takes time for students to digest TVM concepts and to learn how to do the required calculations, so it is good to cover TVM concepts early and often.
xix
xx
Preface
3. Most students—even those who do not plan to major in finance—are interested
in investments. The ability to learn is a function of individual interest and motivation, so Financial Management’s early coverage of securities and security markets
is pedagogically sound.
4. Once basic concepts have been established, it is easier for students to understand
both how and why corporations make specific decisions in the areas of capital
budgeting, raising capital, working capital management, mergers, and the like.
INTENDED MARKET
AND
USE
Financial Management is designed primarily for use in the introductory MBA finance
course and as a reference text in follow-on case courses and after graduation. There is
enough material for two terms, especially if the book is supplemented with cases and/or
selected readings. The book can also be used as an undergraduate introductory text with
exceptionally good students, or where the introductory course is taught over two terms.
IMPROVEMENTS
IN THE
13TH EDITION
As in every revision, we updated and clarified materials throughout the text, reviewing
the entire book for completeness, ease of exposition, and currency. We made hundreds
of small changes to keep the text up-to-date, with particular emphasis on updating the
real world examples and including the latest changes in the financial environment and
financial theory. In addition, we made a number of larger changes. Some affect all chapters, some involve reorganizing sections among chapters, and some modify material
covered within specific chapters.
CHANGES
THAT
AFFECT ALL CHAPTERS
Reorganization to better accommodate one-semester and two-semester
sequences. Finance is taught as a one-semester course at many schools, so we moved
the essential material into the first 17 chapters. The remaining chapters cover additional topics and provide more advanced treatment of the essential material in the first
17 chapters. This makes it easy for a professor teaching a one-semester course to cover
the essential materials and then pick and choose from the remaining topics if time permits. If finance is taught in a two-semester sequence, the first semester can focus on
the essential materials in the first 17 chapters and the second semester can focus on
advanced materials in the remaining chapters, perhaps supplemented with cases.
The global economic crisis. In virtually every chapter we use real world examples
to show how the chapter’s topics are related to some aspect of the global economic
crisis. In addition, many chapters have new “Global Economic Crisis” boxes that focus on particularly important issues related to the crisis.
The big picture. Students often fail to see the forest for the trees, and this is especially true in finance because students must learn new vocabularies and analytical
tools. To help students understand the big picture and integrate the different parts
into an overall framework, we have added a graphic at the beginning of each chapter (and in the PowerPoint shows) that clearly illustrates where the chapter’s topics
fit into the big picture. Following is an example from Chapter 9:
Preface
xxi
Determinants of Intrinsic Value:
The Weighted Average Cost of Capital
Net operating
profit after taxes
Free cash flow
(FCF)
Value =
Required investments
in operating capital
−
FCF1
+
(1 + WACC)1
FCF2
=
+ …+
(1 + WACC)2
FCF∞
(1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion
Cost of debt
Cost of equity
Firm’s debt/equity mix
Firm’s business risk
Additional integration of the textbook and the accompanying Excel Tool Kit
spreadsheet models for each chapter. Many figures in the textbook are actually
screen shots from the chapter’s Excel Tool Kit model. This makes the analysis more
transparent to the students and better enables them to follow the analysis in the Excel
model.
Signficant Reorganization of Some Chapters
Financial markets and performance measures. Chapter 1 still addresses the
financial environment, but now is followed by two chapters focused on measuring
the firm’s performance in the financial environment by understanding financial statements, calculating free cash flow, and analyzing ratios.
Time value of money and bond valuation. Chapter 4 covers the time value of
money and Chapter 5 applies these concepts to bond pricing. Thus, students learn a
tool and then immediately use the tool.
Dividends and stock repurchases before capital structure decisions. We now
cover dividends and stock repurchases in Chapter 14 so that students will already understand stock repurchases when we discuss recapitalizations in Chapter 15.
Notable Changes within Selected Chapters
We made too many small improvements within each chapter to mention them all,
but some of the more notable ones are discussed below.
Chapter 1: An Overview of Financial Management and the Financial
Environment. We added a new box on globalization, “Columbus Was Wrong—
xxii
Preface
the World Is Flat! And Hot, and Crowded,” and a new box on the global economic
crisis, “Say Hello to the Global Economic Crisis!” We completely rewrote the section on financial securities, including a discussion of securitization, and added a new
section on the global crisis. New figures showing the national debt, trade balances,
federal budget deficits and the Case-Shiller real estate index help us better illustrate
different aspects of the global crisis.
Chapter 2: Financial Statements, Cash Flow, and Taxes. A new opening vignette shows the cash that several different companies generated and the different ways
that they used the cash flow. We added a new box on the global economic crisis that
explains the problems associates with off-balance-sheet assets, “Let’s Play Hideand-Seek!” We added a new figure illustrating the uses of free cash flow. We now have
two end-of-chapter spreadsheet problems, one focusing on the articulation between the
income statement and statement of cash flows, and one focusing on free cash flow.
Chapter 3: Analysis of Financial Statements. We added a new box on marking
to market, “The Price is Right! (Or Wrong!),” and a new box on international accounting standards, “The World Might be Flat, but Global Accounting is Bumpy!
The Case of IFRS versus FASB.” We have included discussion of the price/EBITDA
ratio, gross profit margin, and operating profit margin; we also explain how to use
the statement of cash flows in financial analysis.
Chapter 4: Time Value of Money. We added three new boxes: (1) “Hints on
Using Financial Calculators,” (2) “Variable Annuities: Good or Bad?”, and (3) “An
Accident Waiting to Happen: Option Reset Adjustable Rate Mortgages.”
Chapter 5: Bonds, Bond Valuation, and Interest Rates. We added four new
boxes related to the global economic crisis: (1) “Betting With or Against the U.S.
Government: The Case of Treasury Bond Credit Default Swaps,” (2) “Insuring
with Credit Default Swaps: Let the Buyer Beware!” (3) “Might the U.S. Treasury
Bond Be Downgraded?” and (4) “Are Investors Rational?” We also added a new table
summarizing corporate bond default rates and annual changes in ratings.
Chapter 6: Risk, Return, and the Capital Asset Pricing Model. The new opening vignette discusses the recent stock market and compares the market’s returns to GE’s
returns. We added a new box on the risk that remains even for long-term investors,
“What Does Risk Really Mean?” We added two additional boxes on risk, “How Risky
Is a Large Portfolio of Stocks?” and “Another Kind of Risk: The Bernie Madoff Story.”
Chapter 7: Stocks, Stock Valuation, and Stock Market Equilibrium. A new
opening vignette discusses buy- and sell-side analysts. We added a new box on behavioral issues, “Rational Behavior vs. Animal Spirits, Herding, and Anchoring
Bias.” We added a new section, “The Market Stock Price vs. Intrinsic Value.”
Chapter 8: Financial Options and Applications in Corporate Finance. We
completely rewrote the description of the binomial option pricing model. In addition
to the hedge portfolio, we also discuss replicating portfolios. We now provide the
binomial formula and we show the complete solution to the 2-period model. To provide greater continuity, the company used to illustrate the binomial example is now
the same company used to illustrate the Black-Scholes model. Our discussion of put
options now includes the Black-Scholes put formula.
Chapter 9: The Cost of Capital. We added a new figure to highlight the similarities and differences among capital structure weights based on book values, market
Preface
xxiii
values, and target values. We added a new box, “GE and Warren Buffett: The Cost
of Preferred Stock.” We completely rewrote our discussion of the market risk premium, which now includes the impact of stock repurchases on estimating the market
risk premium. We also present data from surveys identifying the market risk premia
used by CFOs and professors.
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows. We
added a new box, “Why NPV is Better than IRR.”
Chapter 11: Cash Flow Estimation and Risk Analysis. We now show how to
use tornado diagrams in sensitivity analysis. We rewrote our discussion of Monte
Carlo simulation and show how to conduct a simulation analysis without using addins but instead using only Excel’s built-in features (Data Tables and random number
generators). We have included an example of replacement analysis and an example of
a decision tree showing abandonment. We added a new box, “Are Bank Stress Tests
Stressful Enough?”
Chapter 12: Financial Planning and Forecasting Financial Statements. It is
difficult to do financial planning without using spreadsheet software, so we
completely rewrote the chapter and explicitly integrated the text and the Excel Tool
Kit model. We illustrate the ways that financial policies (i.e., dividend payout and
capital structure choices) affect financial projections, including ways to ensure that
balance sheets balance. The Excel Tool Kit model now shows a very simple way to
incorporate financing feedback effects.
Chapter 13: Corporate Valuation, Value-Based Management, and Corporate
Governance. The new opening vignette discusses the role of corporate governance in
the global economic crisis. We also added three new boxes. The first describes corporate governance issues at IBM, “Let’s Go to Miami! IBM’s 2009 Annual Meeting.”
The second discusses leadership at bailout recipients, “Would the U.S. Government
be an Effective Board Director?” The third discusses the 2009 proxy season, “Shareholder Reactions to the Crisis.”
Chapter 14: Distributions to Shareholders: Dividends and Repurchases. We
consolidated the coverage of stock repurchases that had been spread over two chapters and
located it here, which now precedes our discussion of capital structure in Chapter 15. We
also use the FCF valuation model to illustrate the different impacts of stock repurchases
versus dividend payments. We added two new boxes. The first discusses recent dividend
cuts, “Will Dividends Ever Be the Same?” and the second discusses Sun Microsystem’s
stock splits and recent reverse split, “Talk About a Split Personality!”
Chapter 15: Capital Structure Decisions. The new opening vignette discusses recent bankruptcies and Black & Decker efforts to reduce liquidity risk by refinancing
short-term debt with long-term debt. Because the stock repurchases are now covered
in the preceding chapter, we were able to improve our discussion of recapitalizations
within the context of the FCF valuation model. We added a new box, “Deleveraging”
that discusses the changes in leverage many companies and individuals are making in
light of the global economic crisis.
Chapter 16: Working Capital Management. We reorganized the chapter so
that we now discuss working capital holdings and financing before discussing
the cash conversion cycle. We rewrote our coverage of the cash conversion cycle to
explain the general concepts and then apply them to actual financial statement data.
xxiv
Preface
We added the box “Some Firms Operate with Negative Working Capital!” and a
new section on the cost of cost of bank loans.
Chapter 17: Multinational Financial Management. We added a new opening
vignette on the global economic crisis and its impact on world economies, foreign
direct investment, and cross-border M&As. We added two new boxes, the first on
regulating international bribery and taxation, “Greasing the Wheels of International
Business.” The second new box discusses the wave of foreign companies partnering
with Chinese banks to provide consumer finance services, “Consumer Finance in
China.”
Chapter 18: Lease Financing. The new opening vignette discusses Virgin Atlantic’s order of 10 Airbus jets to be leased from AerCap. A new box addresses the
FASB/IASB movement to capitalize all leases, “Off-Balance Sheet Financing: Is it
Going to Disappear?”
Chapter 19: Hybrid Financing: Preferred Stock, Warrants, and Convertibles.
The new opening vignette discusses the Treasury Department’s use of preferred stock
and warrants to support troubled companies. A new box discusses the use of paymentin-kind preferred stock in the merger of Dow Chemical Company and Rohm & Haas,
“The Romance Had No Chemistry, But It Had a Lot of Preferred Stock!”
Chapter 20: Initial Public Offerings, Investment Banking, and Financial
Restructuring. The new opening vignette discusses three companies that recently
raised capital via an initial public offering, a seasoned stock offering, and a debt offering. We added a new section on investment banking activities. We added a new box
on “Investment Banks and the Global Economic Crisis.”
Chapter 21: Mergers, LBOs, Divestitures, and Holding Companies. We
added a section explaining how the stock-swap ratio is determined for mergers where
the payment is in the form of the acquiring company’s stock.
Chapter 22: Bankruptcy, Reorganization, and Liquidation. The new opening
vignette discusses the bankruptcies of Lehman Brothers, Washington Mutual, Chrysler, and General Motors. We added a new box on personal and small business bankruptcies, “A Nation of Defaulters?”.
Chapter 23: Derivatives and Risk Management. The new opening vignette
discusses risk management at Koch Industries, Navistar, and Pepsi. We added a new
box on “Value at Risk and Enterprise Risk Management.” Throughout the chapter
we discuss the failure of risk management during the global economic crisis.
Chapter 24: Portfolio Theory, Asset Pricing Models, and Behavioral
Finance. We added a box on the WSJ contest between dart-throwers and investors,
“Skill or Luck?”. We expanded our discussion of the Fama-French 3-factor model and
included a table showing returns of portfolios formed by sorting on size and the bookto-market ratio.
Chapter 25: Real Options. The new opening vignette discusses Honda’s flexible
manufacturing plants.
Aplia Finance
Aplia Finance, an interactive learning system, engages students in course concepts,
ensures they practice on a regular basis, and helps them prepare to learn finance
through a series of tutorials. Created by an instructor to help students excel, book-
Preface
xxv
specific problem sets have instant grades and detailed feedback, ensuring students
have the opportunity to learn from and improve with every question.
Chapter assignments use the same language and tone of the course textbook, giving students a seamless experience in and out of the classroom. Problems are automatically graded and offer detailed explanations, helping stude
ACP
ADR
APR
AR
b
bL
bU
BEP
BVPS
CAPM
CCC
CF
CFPS
CR
CV
Δ
Dps
Dt
DCF
D/E
DPS
DRIP
DRP
DSO
EAR
EBIT
EBITDA
EPS
EVA
F
FCF
FVN
FVAN
g
I
I/YR
INT
IP
IPO
IRR
LP
M
M/B
MIRR
MRP
MVA
n
N
N(di)
NOPAT
NOWC
NPV
P
Pc
Average collection period
American Depository Receipt
Annual percentage rate
Accounts receivable
Beta coefficient, a measure of an asset’s market risk
Levered beta
Unlevered beta
Basic earning power
Book value per share
Capital Asset Pricing Model
Cash conversion cycle
Cash flow; CFt is the cash flow in Period t
Cash flow per share
Conversion ratio
Coefficient of variation
Difference, or change (uppercase delta)
Dividend of preferred stock
Dividend in Period t
Discounted cash flow
Debt-to-equity ratio
Dividends per share
Dividend reinvestment plan
Default risk premium
Days sales outstanding
Effective annual rate, EFF%
Earnings before interest and taxes; net operating income
Earnings before interest, taxes, depreciation, and amortization
Earnings per share
Economic Value Added
(1) Fixed operating costs
(2) Flotation cost
Free cash flow
Future value for Year N
Future value of an annuity for N years
Growth rate in earnings, dividends, and stock prices
Interest rate; also denoted by r
Interest rate key on some calculators
Interest payment in dollars
Inflation premium
Initial public offering
Internal rate of return
Liquidity premium
(1) Maturity value of a bond
(2) Margin (profit margin)
Market-to-book ratio
Modified Internal Rate of Return
Maturity risk premium
Market Value Added
Number of shares outstanding
Calculator key denoting number of periods
Represents area under a standard normal distribution function
Net operating profit after taxes
Net operating working capital
Net present value
(1) Price of a share of stock in Period t; P0 = price of the stock today
(2) Sales price per unit of product sold
Conversion price
Pf
Ph
PN
P/E
PMT
PPP
PV
PVAN
Q
QBE
r
¯r
^r
r*
rd
re
rf
rh
ri
rM
rNOM
rps
rPER
rRF
rs
ρ
ROA
ROE
RP
RPM
RR
S
SML
∑
σ
σ2
t
T
TVN
TIE
V
VB
VL
Vop
Vps
VU
VC
w
wd
wps
ws
wce
WACC
X
YTC
YTM
Price of good in foreign country
Price of good in home country
A stock’s horizon, or terminal, value
Price/earnings ratio
Payment of an annuity
Purchasing power parity
Present value
Present value of an annuity for N years
Quantity produced or sold
Breakeven quantity
(1) A percentage discount rate, or cost of capital; also denoted by i
(2) Nominal risk-adjusted required rate of return
“r bar,” historic, or realized, rate of return
“r hat,” an expected rate of return
Real risk-free rate of return
Before-tax cost of debt
Cost of new common stock (outside equity)
Interest rate in foreign country
Interest rate in home country
Required return for an individual firm or security
Return for “the market” or for an “average” stock
Nominal rate of interest; also denoted by iNOM
(1) Cost of preferred stock
(2) Portfolio’s return
Periodic rate of return
Rate of return on a risk-free security
(1) Required return on common stock
(2) Cost of old common stock (inside equity)
Correlation coefficient (lowercase rho); also denoted by R when using historical data
Return on assets
Return on equity
Risk premium
Market risk premium
Retention rate
(1) Sales
(2) Estimated standard deviation for sample data
(3) Intrinsic value of stock (i.e., all common equity)
Security Market Line
Summation sign (uppercase sigma)
Standard deviation (lowercase sigma)
Variance
Time period
Marginal income tax rate
A stock’s horizon, or terminal, value
Times interest earned
Variable cost per unit
Bond value
Total market value of a levered firm
Value of operations
Value of preferred stock
Total market value of an unlevered firm
Total variable costs
Proportion or weight
Weight of debt
Weight of preferred stock
Weight of common equity raised internally by retaining earnings
Weight of common equity raised externally by issuing stock
Weighted averaged cost of capital
Exercise price of option
Yield to call
Yield to maturity
Financial Management:
Theory and Practice
THIRTEENTH EDITION
MICHAEL C. EHRHARDT
University of Tennessee
EUGENE F. BRIGHAM
University of Florida
Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States
Financial Management: Theory and Practice,
Thirteen Edition
Michael C. Ehrhardt and Eugene F. Brigham
VP/Editorial Director:
Jack W. Calhoun
Publisher:
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1 2 3 4 5 6 7 14 13 12 11 10
Brief Contents
Preface
PART 1
xix
Fundamental Concepts
1
of Corporate Finance
CHAPTER 1 An Overview of Financial
Management and the Financial
Environment 3
Web Extensions
PART 3
Web Extensions
1B: A Closer Look at the Stock
Markets
Web Extensions
2A: The Federal Income Tax
System for Individuals
CHAPTER 3 Analysis of Financial
Statements 87
PART 2
123
CHAPTER 7 Stocks, Stock Valuation,
and Stock Market
Equilibrium 267
7A: Derivation of Valuation
Equations
CHAPTER 8 Financial Options and Applications
in Corporate Finance 305
Web Extensions
PART 4
4A: The Tabular Approach
4B: Derivation of Annuity Formulas
4C: Continuous Compounding
CHAPTER 5 Bonds, Bond Valuation, and
Interest Rates 173
Web Extensions
6A: Continuous Probability
Distributions
6B: Estimating Beta with
a Financial Calculator
Fixed Income
Securities 121
CHAPTER 4 Time Value of Money
Web Extensions
215
CHAPTER 6 Risk, Return, and the Capital
Asset Pricing Model 217
1A: An Overview of Derivatives
CHAPTER 2 Financial Statements, Cash Flow,
and Taxes 47
Stocks and Options
5A: A Closer Look at Zero
Coupon Bonds
5B: A Closer Look at TIPS:
Treasury Inflation-Protected
Securities
5C: A Closer Look at Bond Risk:
Duration
5D: The Pure Expectations Theory
and Estimation of Forward Rates
Projects and Their
Valuation 333
CHAPTER 9 The Cost of Capital
335
9A: The Required Return
Assuming Nonconstant Dividends
and Stock Repurchases
CHAPTER 10 The Basics of Capital Budgeting:
Evaluating Cash Flows 379
Web Extensions
10A: The Accounting Rate of
Return (ARR)
CHAPTER 11 Cash Flow Estimation and Risk
Analysis 423
Web Extensions
Web Extensions
11A: Certainty Equivalents
and Risk-Adjusted Discount
Rates
iii
iv
Brief Contents
PART 5
Corporate Valuation
and Governance 471
CHAPTER 12 Financial Planning and
Forecasting Financial
Statements 473
12A: Advanced Techniques for
Forecasting Financial Statements
Accounts
CHAPTER 13 Corporate Valuation,
Value-Based Management
and Corporate Governance 511
Web Extensions
PART 6
Cash Distributions and
Capital Structure 557
CHAPTER 14 Distributions to Shareholders:
Dividends and Repurchases 559
CHAPTER 15 Capital Structure
Decisions 599
Web Extensions
15A: Degree of Leverage
PART 7
Managing Global
Operations 639
CHAPTER 16 Working Capital
Management 641
16A: Secured Short-Term
Financing
CHAPTER 17 Multinational Financial
Management 691
CHAPTER 19 Hybrid Financing: Preferred
Stock, Warrants, and
Convertibles 759
Web Extensions
19A: Calling Convertible
Issues
CHAPTER 20 Initial Public Offerings,
Investment Banking,
and Financial
Restructuring 787
Web Extensions
20A: Rights Offerings
PART 9
Special Topics
825
CHAPTER 21 Mergers, LBOs, Divestitures, and
Holding Companies 827
Web Extensions
21A: Projecting Consistent Debt
and Interest Expenses
CHAPTER 22 Bankruptcy, Reorganization, and
Liquidation 869
Web Extensions
22A: Multiple Discriminant
Analysis
CHAPTER 23 Derivatives and Risk
Management 899
Web Extensions
23A: Risk Management with
Insurance
Web Extensions
PART 8
Tactical Financing
Decisions 731
CHAPTER 18 Lease Financing
Web Extensions
733
18A: Leasing Feedback
18B: Percentage Cost Analysis
18C: Leveraged Leases
PART 10
Advanced Issues
929
CHAPTER 24 Portfolio Theory, Asset Pricing
Models, and Behavioral
Finance 931
CHAPTER 25 Real Options
Web Extensions
971
25A: The Abandonment Real
Option
25B: Risk-Neutral Valuation
CHAPTER 26 Analysis of Capital Structure
Theory 995
Brief Contents
Appendixes
Appendix A Solutions to Self-Test
Problems 1029
Appendix B Answers to End-of-Chapter
Problems 1063
Appendix C Selected Equations and
Data 1071
Appendix D Values of the Areas under the
Standard Normal Distribution
Function 1085
Glossary 1087
Name Index 1113
Subject Index 1119
Web Chapters
CHAPTER 27 Providing and Obtaining Credit
CHAPTER 28 Advanced Issues in Cash
Management and Inventory
Control
CHAPTER 29 Pension Plan Management
CHAPTER 30 Financial Management in
Not-for-Profit Businesses
v
Contents
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xix
PART 1 Fundamental Concepts of Corporate Finance 1
CHAPTER 1
An Overview of Financial Management and the Financial Environment
The Five-Minute MBA
4
5
Box: Say Hello to the Global Economic Crisis!
The Corporate Life Cycle
5
Box: Columbus Was Wrong—the World Is Flat! And Hot, and Crowded!
The Primary Objective of the Corporation: Value Maximization
Box: Ethics for Individuals and Businesses
10
Box: Corporate Scandals and Maximizing Stock Price 13
An Overview of the Capital Allocation Process
Financial Securities
15
The Cost of Money
19
Financial Institutions
Financial Markets
23
27
Trading Procedures in Financial Markets
Types of Stock Market Transactions
Box: Rational Exuberance?
Box: Measuring the Market
Stock Market Returns
Summary
31
33
34
The Global Economic Crisis
e-Resources
29
30
31
The Secondary Stock Markets
The Big Picture
13
36
42
43
44
Web Extensions
1A: An Overview of Derivatives
1B: A Closer Look at the Stock Markets
CHAPTER 2
Financial Statements, Cash Flow, and Taxes
47
Box: Intrinsic Value, Free Cash Flow, and Financial Statements
Financial Statements and Reports
The Balance Sheet
49
Box: Let’s Play Hide-and-Seek!
vi
51
48
48
9
6
3
Contents
The Income Statement
52
Statement of Stockholders’ Equity
Net Cash Flow
53
54
Statement of Cash Flows
55
Box: Financial Analysis on the WEB 56
Modifying Accounting Data for Managerial Decisions
MVA and EVA
67
Box: Sarbanes-Oxley and Financial Fraud
The Federal Income Tax System
Summary
59
63
Box: Financial Bamboozling: How to Spot It
70
71
76
Web Extensions
2A: The Federal Income Tax System for Individuals
CHAPTER 3
Analysis of Financial Statements
87
88
Box: Intrinsic Value and Analysis of Financial Statements
Financial Analysis
88
Liquidity Ratios
89
Asset Management Ratios
92
Box: The Price is Right! (Or Wrong!)
Debt Management Ratios
Profitability Ratios
93
95
98
Box: The World Might be Flat, but Global Accounting is Bumpy!
The Case of IFRS versus FASB 99
Market Value Ratios
100
Trend Analysis, Common Size Analysis, and Percentage Change Analysis
Tying the Ratios Together: The Du Pont Equation
Comparative Ratios and Benchmarking
107
Uses and Limitations of Ratio Analysis
108
Box: Ratio Analysis on the Web
Looking beyond the Numbers
Summary
106
109
110
110
PART 2 Fixed Income Securities 121
CHAPTER 4
Time Value of Money
123
Box: Corporate Valuation and the Time Value of Money 124
Time Lines
125
Future Values
125
Box: Hints on Using Financial Calculators
129
Box: The Power of Compound Interest 132
Present Values
133
102
vii
viii
Contents
Finding the Interest Rate, I
136
Finding the Number of Years, N
Annuities
137
138
Future Value of an Ordinary Annuity
Future Value of an Annuity Due
138
141
Present Value of Ordinary Annuities and Annuities Due
Finding Annuity Payments, Periods, and Interest Rates
Perpetuities
141
144
Box: Variable Annuities: Good or Bad?
144
146
Box: Using the Internet for Personal Financial Planning
Uneven, or Irregular, Cash Flows
147
148
Future Value of an Uneven Cash Flow Stream
Solving for I with Irregular Cash Flows
151
152
Semiannual and Other Compounding Periods
153
Box: Truth in Lending: What Loans Really Cost 156
Fractional Time Periods
Amortized Loans
157
158
Growing Annuities
159
Box: An Accident Waiting to Happen: Option Reset
Adjustable Rate Mortgages 160
Summary
162
Web Extensions
4A: The Tabular Approach
4B: Derivation of Annuity Formulas
4C: Continuous Compounding
CHAPTER 5
Bonds, Bond Valuation, and Interest Rates
Box: Intrinsic Value and the Cost of Debt
Who Issues Bonds?
173
174
174
Key Characteristics of Bonds
175
Box: Betting With or Against the U.S. Government:
The Case of Treasury Bond Credit Default Swaps 176
Bond Valuation
180
Changes in Bond Values over Time
Box: Drinking Your Coupons
Bonds with Semiannual Coupons
Bond Yields
184
187
187
188
The Pre-Tax Cost of Debt: Determinants of Market Interest Rates
The Real Risk-Free Rate of Interest, r*
The Inflation Premium (IP)
192
193
The Nominal, or Quoted, Risk-Free Rate of Interest, rRF
The Default Risk Premium (DRP)
195
195
Box: Insuring with Credit Default Swaps: Let the Buyer Beware!
197
191
Contents
Box: Might the U.S. Treasury Bond Be Downgraded?
Box: Are Investors Rational?
201
The Maturity Risk Premium (MRP)
201
The Term Structure of Interest Rates
204
205
Bankruptcy and Reorganization
Summary
199
201
The Liquidity Premium (LP)
Financing with Junk Bonds
ix
206
207
Web Extensions
5A: A Closer Look at Zero Coupon Bonds
5B: A Closer Look at TIPS: Treasury Inflation-Protected Securities
5C: A Closer Look at Bond Risk: Duration
5D: The Pure Expectations Theory and Estimation of Forward Rates
PART 3 Stocks and Options 215
CHAPTER 6
Risk, Return, and the Capital Asset Pricing Model
Box: Intrinsic Value, Risk, and Return
Returns on Investments
Stand-Alone Risk
217
219
219
220
Box: What Does Risk Really Mean?
227
229
Box: The Trade-off between Risk and Return
Risk in a Portfolio Context
231
236
Box: How Risky Is a Large Portfolio of Stocks?
Box: The Benefits of Diversifying Overseas
Calculating Beta Coefficients
239
243
The Relationship between Risk and Return
246
Box: Another Kind of Risk: The Bernie Madoff Story
Some Concerns about Beta and the CAPM
252
253
Some Concluding Thoughts: Implications for Corporate Managers and Investors
Summary
255
Web Extensions
6A: Continuous Probability Distributions
6B: Estimating Beta with a Financial Calculator
CHAPTER 7
Stocks, Stock Valuation, and Stock Market Equilibrium
Box: Corporate Valuation and Stock Prices
268
Legal Rights and Privileges of Common Stockholders
Types of Common Stock
269
The Market Stock Price versus Intrinsic Value
Stock Market Reporting
272
270
268
267
253
x
Contents
Valuing Common Stocks
273
Valuing a Constant Growth Stock
276
Expected Rate of Return on a Constant Growth Stock
Valuing Nonconstant Growth Stocks
281
Stock Valuation by the Free Cash Flow Approach
Market Multiple Analysis
Preferred Stock
279
285
285
286
Stock Market Equilibrium
287
The Efficient Markets Hypothesis
290
Box: Rational Behavior versus Animal Spirits, Herding, and Anchoring Bias 293
Summary
294
Web Extensions
7A: Derivation of Valuation Equations
CHAPTER 8
Financial Options and Applications in Corporate Finance
Box: The Intrinsic Value of Stock Options
Overview of Financial Options
306
306
309
Box: Financial Reporting for Employee Stock Options
The Single-Period Binomial Option Pricing Approach
310
The Single-Period Binomial Option Pricing Formula
The Multi-Period Binomial Option Pricing Model
The Black-Scholes Option Pricing Model (OPM)
Box: Taxes and Stock Options
The Valuation of Put Options
314
316
319
324
325
Applications of Option Pricing in Corporate Finance
Summary
305
326
328
PART 4 Projects and Their Valuation 333
CHAPTER 9
The Cost of Capital
335
Box: Corporate Valuation and the Cost of Capital
The Weighted Average Cost of Capital
Basic Definitions
336
337
338
Cost of Debt, rd(1 − T)
340
Cost of Preferred Stock, rps
342
Box: GE and Warren Buffett: The Cost of Preferred Stock
Cost of Common Stock, rs
The CAPM Approach
343
344
345
Dividend-Yield-Plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach
Over-Own-Bond-Yield-Plus-Judgmental-Risk-Premium Approach
353
355
Comparison of the CAPM, DCF, and Over-Own-Bond-Yield-Plus-Judgmental-RiskPremium Methods 356
Contents
Adjusting the Cost of Equity for Flotation Costs
357
Composite, or Weighted Average, Cost of Capital, WACC
358
Box: Global Variations in the Cost of Capital 361
Factors That Affect the WACC
361
Adjusting the Cost of Capital for Risk
363
Privately Owned Firms and Small Businesses
Four Mistakes to Avoid
Summary
366
367
368
Web Extensions
9A: The Required Return Assuming Nonconstant Dividends and Stock Repurchases
CHAPTER 10
The Basics of Capital Budgeting: Evaluating Cash Flows
381
Box: Corporate Valuation and Capital Budgeting
An Overview of Capital Budgeting
Net Present Value (NPV)
381
383
Internal Rate of Return (IRR)
387
Box: Why NPV Is Better Than IRR
Multiple Internal Rates of Return
Reinvestment Rate Assumptions
389
390
392
Modified Internal Rate of Return (MIRR)
NPV Profiles
396
Profitability Index (PI)
Payback Period
400
401
Conclusions on Capital Budgeting Methods
Decision Criteria Used in Practice
405
Other Issues in Capital Budgeting
405
Summary
393
403
411
Web Extensions
10A: The Accounting Rate of Return (ARR)
CHAPTER 11
Cash Flow Estimation and Risk Analysis
423
Box: Corporate Valuation, Cash Flows, and Risk Analysis
Conceptual Issues
424
Analysis of an Expansion Project
Risk Analysis in Capital Budgeting
Measuring Stand-Alone Risk
Sensitivity Analysis
Scenario Analysis
424
429
435
436
436
439
Monte Carlo Simulation
442
Box: Are Bank Stress Tests Stressful Enough? 445
Project Risk Conclusions
446
Box: Capital Budgeting Practices in the Asian/Pacific Region
447
379
xi
xii
Contents
Replacement Analysis 448
Real Options 449
Phased Decisions and Decision Trees
451
Summary 454
Appendix 11A Tax Depreciation 468
Web Extensions
11A: Certainty Equivalents and Risk-Adjusted Discount Rates
PART 5 Corporate Valuation and Governance 471
CHAPTER 12
Financial Planning and Forecasting Financial Statements
Box: Corporate Valuation and Financial Planning
Overview of Financial Planning 474
Sales Forecast 476
Additional Funds Needed (AFN) Method
473
474
478
Forecasted Financial Statements Method 482
Forecasting When the Ratios Change 496
Summary
499
Web Extensions
12A: Advanced Techniques for Forecasting Financial Statements Accounts
CHAPTER 13
Corporate Valuation, Value-Based Management and Corporate
Governance 511
Box: Corporate Valuation: Putting the Pieces Together
Overview of Corporate Valuation
The Corporate Valuation Model
Value-Based Management
513
514
521
Managerial Behavior and Shareholder Wealth
Corporate Governance
512
530
531
Box: Let’s Go to Miami! IBM’s 2009 Annual Meeting 533
Box: Would the U.S. Government Be an Effective Board Director?
Box: Shareholder Reactions to the Crisis
538
Box: The Sarbanes-Oxley Act of 2002 and Corporate Governance
Box: International Corporate Governance
540
542
Employee Stock Ownership Plans (ESOPs)
Summary
536
543
546
PART 6 Cash Distributions and Capital Structure 557
CHAPTER 14
Distributions to Shareholders: Dividends and Repurchases
Box: Uses of Free Cash Flow: Distributions to Shareholders
An Overview of Cash Distributions
560
560
559
Contents
Procedures for Cash Distributions
562
Cash Distributions and Firm Value
Clientele Effect
564
567
Information Content, or Signaling, Hypothesis
Implications for Dividend Stability
568
569
Box: Will Dividends Ever Be the Same?
570
Setting the Target Distribution Level: The Residual Distribution Model
The Residual Distribution Model in Practice
572
A Tale of Two Cash Distributions: Dividends versus Stock Repurchases
The Pros and Cons of Dividends and Repurchases
Box: Dividend Yields around the World 584
Other Factors Influencing Distributions 584
Summarizing the Distribution Policy Decision
Stock Splits and Stock Dividends 587
Dividend Reinvestment Plans
Summary
585
590
591
CHAPTER 15
Capital Structure Decisions
599
Box: Corporate Valuation and Capital Structure
A Preview of Capital Structure Issues
Business Risk and Financial Risk
Capital Structure Theory
600
609
611
Capital Structure Evidence and Implications
618
Box: Taking a Look at Global Capital Structures
Estimating the Optimal Capital Structure
Anatomy of a Recapitalization
Box: Deleveraging
600
603
Box: Yogi Berra on the MM Proposition
Summary
582
588
Box: Talk about a Split Personality!
620
621
625
630
630
Web Extensions
15A: Degree of Leverage
PART 7 Managing Global Operations 639
CHAPTER 16
Working Capital Management
641
Box: Corporate Valuation and Working Capital Management
Current Asset Holdings
The Cash Conversion Cycle
644
648
Box: Some Firms Operate with Negative Working Capital!
The Cash Budget
654
642
643
Current Assets Financing Policies
570
653
573
xiii
xiv
Contents
Cash Management and the Target Cash Balance
658
Box: The CFO Cash Management Scorecard
Cash Management Techniques
Inventory Management
659
661
662
Box: Supply Chain Management
Receivables Management
663
665
Box: Supply Chain Finance
Accruals and Accounts Payable (Trade Credit)
Short-Term Marketable Securities
Short-Term Financing
670
672
676
Use of Security in Short-Term Financing
Summary
667
672
Short-Term Bank Loans
Commercial Paper
657
677
678
Web Extensions
16A: Secured Short-Term Financing
CHAPTER 17
Multinational Financial Management
691
Box: Corporate Valuation in a Global Context 692
Multinational, or Global, Corporations
692
Multinational versus Domestic Financial Management
Exchange Rates
693
694
Exchange Rates and International Trade
698
The International Monetary System and Exchange Rate Policies
Trading in Foreign Exchange
Interest Rate Parity
703
704
Purchasing Power Parity
706
708
Box: Hungry for a Big Mac? Go To Malaysia!
Inflation, Interest Rates, and Exchange Rates
International Money and Capital Markets
709
710
Box: Greasing the Wheels of International Business
Box: Stock Market Indices around the World
Multinational Capital Budgeting
Box: Consumer Finance in China
International Capital Structures
713
714
715
718
Multinational Working Capital Management
Summary
711
720
723
PART 8 Tactical Financing Decisions 731
CHAPTER 18
Lease Financing
Types of Leases
733
734
699
Contents
Tax Effects
736
Financial Statement Effects
738
Box: Off–Balance Sheet Financing: Is It Going to Disappear?
Evaluation by the Lessee
740
Evaluation by the Lessor
745
Other Issues in Lease Analysis
747
Box: What You Don’t Know Can Hurt You!
748
750
Box: Lease Securitization
Other Reasons for Leasing
Summary
740
751
753
Web Extensions
18A: Leasing Feedback
18B: Percentage Cost Analysis
18C: Leveraged Leases
CHAPTER 19
Hybrid Financing: Preferred Stock, Warrants, and Convertibles
Preferred Stock
761
Box: The Romance Had No Chemistry, But It Had a Lot of Preferred Stock!
Warrants
762
765
Convertible Securities
770
A Final Comparison of Warrants and Convertibles
777
Reporting Earnings When Warrants or Convertibles Are Outstanding
Summary
759
778
779
Web Extensions
19A: Calling Convertible Issues
CHAPTER 20
Initial Public Offerings, Investment Banking, and Financial
Restructuring 787
The Financial Life Cycle of a Start-up Company
The Decision to Go Public
788
789
The Process of Going Public: An Initial Public Offering
Equity Carve-outs: A Special Type of IPO
791
799
Other Ways to Raise Funds in the Capital Markets
Box: Bowie Bonds Ch-Ch-Change Asset Securitization
800
803
Investment Banking Activities and Their Role in the Global Economic Crisis
Box: Investment Banks and the Global Economic Crisis
The Decision to Go Private
806
Managing the Maturity Structure of Debt
Refunding Operations
805
808
810
Box: TVA Ratchets Down Its Interest Expenses
813
Managing the Risk Structure of Debt with Project Financing
Summary
817
Web Extensions
20A: Rights Offerings
815
803
xv
xvi
Contents
PART 9 Special Topics 825
CHAPTER 21
Mergers, LBOs, Divestitures, and Holding Companies
Rationale for Mergers
Types of Mergers
827
828
830
Level of Merger Activity
831
Hostile versus Friendly Takeovers
Merger Regulation
832
833
Overview of Merger Analysis
834
The Adjusted Present Value (APV) Approach
835
The Free Cash Flow to Equity (FCFE) Approach
838
Illustration of the Three Valuation Approaches for a Constant Capital Structure
Setting the Bid Price
845
Analysis When There Is a Permanent Change in Capital Structure
Taxes and the Structure of the Takeover Bid
850
Box: Tempest in a Teapot?
Financial Reporting for Mergers
852
Analysis for a “True Consolidation”
The Role of Investment Bankers
Corporate Alliances
Leveraged Buyouts
Divestitures
857
858
858
859
859
Holding Companies
Summary
855
855
Who Wins: The Empirical Evidence
Box: Merger Mistakes
849
860
862
Web Extensions
21A: Projecting Consistent Debt and Interest Expenses
CHAPTER 22
Bankruptcy, Reorganization, and Liquidation
Financial Distress and Its Consequences
869
870
Issues Facing a Firm in Financial Distress
871
Settlements without Going through Formal Bankruptcy
Federal Bankruptcy Law
874
Reorganization in Bankruptcy
Liquidation in Bankruptcy
Box: A Nation of Defaulters?
875
885
888
Other Motivations for Bankruptcy
Some Criticisms of Bankruptcy Laws
Summary
890
Web Extensions
22A: Multiple Discriminant Analysis
889
889
872
847
840
Contents
CHAPTER 23
Derivatives and Risk Management
899
900
Box: Corporate Valuation and Risk Management
Reasons to Manage Risk
901
Background on Derivatives
Derivatives in the News
903
904
Other Types of Derivatives
907
Corporate Risk Management
913
Box: Enterprise Risk Management and Value at Risk
Using Derivatives to Reduce Risks
917
Box: Risk Management in the Cyber Economy
Summary
916
920
924
Web Extensions
23A: Risk Management with Insurance
PART 10 Advanced Issues 929
CHAPTER 24
Portfolio Theory, Asset Pricing Models, and Behavioral Finance
932
Box: Corporate Valuation and Risk
Efficient Portfolios
932
Choosing the Optimal Portfolio
936
The Basic Assumptions of the Capital Asset Pricing Model
The Capital Market Line and the Security Market Line
Calculating Beta Coefficients
Box: Skill or Luck?
939
940
944
945
Empirical Tests of the CAPM
Arbitrage Pricing Theory
952
954
The Fama-French Three-Factor Model
957
An Alternative Theory of Risk and Return: Behavioral Finance
Summary
963
CHAPTER 25
Real Options 971
Valuing Real Options
972
The Investment Timing Option: An Illustration
The Growth Option: An Illustration
Concluding Thoughts on Real Options
Summary
989
Web Extensions
25A: The Abandonment Real Option
25B: Risk-Neutral Valuation
982
986
973
961
931
xvii
xviii
Contents
CHAPTER 26
Analysis of Capital Structure Theory
995
Box: Corporate Valuation and Capital Structure Decisions
996
Capital Structure Theory: Arbitrage Proofs of the Modigliani-Miller Models
Introducing Personal Taxes: The Miller Model
Criticisms of the MM and Miller Models
1010
An Extension of the MM Model: Nonzero Growth and a Risky Tax Shield
Risky Debt and Equity as an Option
1015
Capital Structure Theory: Our View
1019
Summary
996
1006
1011
1021
Appendix
Appendix
Appendix
Appendix
A Solutions to Self-Test Problems . . . . . . . . . . . . . . . . . . . . . . . . . . 1029
B Answers to End-of-Chapter Problems . . . . . . . . . . . . . . . . . . . . . 1063
C Selected Equations and Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1071
D Values of the Areas under the Standard Normal
Distribution Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1085
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1087
Name Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1113
Subject Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1119
WEB CHAPTERS
CHAPTER 27
Providing and Obtaining Credit
CHAPTER 28
Advanced Issues in Cash Management and Inventory Control
CHAPTER 29
Pension Plan Management
CHAPTER 30
Financial Management in Not-for-Profit Businesses
Preface
resource
Be sure to visit the
Financial Management:
Theory and Practice
(13th Edition) Web site at
www.cengage.com/
brigham. This site
provides access for
instructors and students.
When we wrote the first edition of Financial Management: Theory and Practice, we had
four goals: (1) to create a text that would help students make better financial decisions;
(2) to provide a book that could be used in the introductory MBA course, but one that
was complete enough for use as a reference text in follow-on case courses and after
graduation; (3) to motivate students by demonstrating that finance is both interesting
and relevant; and (4) to make the book clear enough so that students could go through
the material without wasting either their time or their professor’s time trying to figure
out what we were saying.
The collapse of the sub-prime mortgage market, the financial crisis, and the global
economic crisis make it more important than ever for students and managers to
understand the role that finance plays in a global economy, in their own companies,
and in their own lives. So in addition to the four goals listed above, this edition has a
fifth goal, to prepare students for a changed world.
INTRINSIC VALUATION
AS A
UNIFYING THEME
Our emphasis throughout the book is on the actions that a manager can and should take
to increase the intrinsic value of the firm. Structuring the book around intrinsic valuation
enhances continuity and helps students see how various topics are related to one another.
As its title indicates, this book combines theory and practical applications. An
understanding of finance theory is absolutely essential for anyone developing and/or
implementing effective financial strategies. But theory alone isn’t sufficient, so we
provide numerous examples in the book and the accompanying Excel spreadsheets to
illustrate how theory is applied in practice. Indeed, we believe that the ability to analyze financial problems using Excel is absolutely essential for a student’s successful job
search and subsequent career. Therefore, many exhibits in the book come directly
from the accompanying Excel spreadsheets. Many of the spreadsheets also provide
brief “tutorials” by way of detailed comments on Excel features that we have found to
be especially useful, such as Goal Seek, Tables, and many financial functions.
The book begins with fundamental concepts, including background on the economic and financial environment, financial statements (with an emphasis on cash
flows), the time value of money, bond valuation, risk analysis, and stock valuation.
With this background, we go on to discuss how specific techniques and decision rules
can be used to help maximize the value of the firm. This organization provides four
important advantages:
1. Managers should try to maximize the intrinsic value of a firm, which is determined
by cash flows as revealed in financial statements. Our early coverage of financial
statements thus helps students see how particular financial decisions affect the various parts of the firm and the resulting cash flow. Also, financial statement analysis
provides an excellent vehicle for illustrating the usefulness of spreadsheets.
2. Covering time value of money early helps students see how and why expected
future cash flows determine the value of the firm. Also, it takes time for students to digest TVM concepts and to learn how to do the required calculations, so it is good to cover TVM concepts early and often.
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Preface
3. Most students—even those who do not plan to major in finance—are interested
in investments. The ability to learn is a function of individual interest and motivation, so Financial Management’s early coverage of securities and security markets
is pedagogically sound.
4. Once basic concepts have been established, it is easier for students to understand
both how and why corporations make specific decisions in the areas of capital
budgeting, raising capital, working capital management, mergers, and the like.
INTENDED MARKET
AND
USE
Financial Management is designed primarily for use in the introductory MBA finance
course and as a reference text in follow-on case courses and after graduation. There is
enough material for two terms, especially if the book is supplemented with cases and/or
selected readings. The book can also be used as an undergraduate introductory text with
exceptionally good students, or where the introductory course is taught over two terms.
IMPROVEMENTS
IN THE
13TH EDITION
As in every revision, we updated and clarified materials throughout the text, reviewing
the entire book for completeness, ease of exposition, and currency. We made hundreds
of small changes to keep the text up-to-date, with particular emphasis on updating the
real world examples and including the latest changes in the financial environment and
financial theory. In addition, we made a number of larger changes. Some affect all chapters, some involve reorganizing sections among chapters, and some modify material
covered within specific chapters.
CHANGES
THAT
AFFECT ALL CHAPTERS
Reorganization to better accommodate one-semester and two-semester
sequences. Finance is taught as a one-semester course at many schools, so we moved
the essential material into the first 17 chapters. The remaining chapters cover additional topics and provide more advanced treatment of the essential material in the first
17 chapters. This makes it easy for a professor teaching a one-semester course to cover
the essential materials and then pick and choose from the remaining topics if time permits. If finance is taught in a two-semester sequence, the first semester can focus on
the essential materials in the first 17 chapters and the second semester can focus on
advanced materials in the remaining chapters, perhaps supplemented with cases.
The global economic crisis. In virtually every chapter we use real world examples
to show how the chapter’s topics are related to some aspect of the global economic
crisis. In addition, many chapters have new “Global Economic Crisis” boxes that focus on particularly important issues related to the crisis.
The big picture. Students often fail to see the forest for the trees, and this is especially true in finance because students must learn new vocabularies and analytical
tools. To help students understand the big picture and integrate the different parts
into an overall framework, we have added a graphic at the beginning of each chapter (and in the PowerPoint shows) that clearly illustrates where the chapter’s topics
fit into the big picture. Following is an example from Chapter 9:
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xxi
Determinants of Intrinsic Value:
The Weighted Average Cost of Capital
Net operating
profit after taxes
Free cash flow
(FCF)
Value =
Required investments
in operating capital
−
FCF1
+
(1 + WACC)1
FCF2
=
+ …+
(1 + WACC)2
FCF∞
(1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion
Cost of debt
Cost of equity
Firm’s debt/equity mix
Firm’s business risk
Additional integration of the textbook and the accompanying Excel Tool Kit
spreadsheet models for each chapter. Many figures in the textbook are actually
screen shots from the chapter’s Excel Tool Kit model. This makes the analysis more
transparent to the students and better enables them to follow the analysis in the Excel
model.
Signficant Reorganization of Some Chapters
Financial markets and performance measures. Chapter 1 still addresses the
financial environment, but now is followed by two chapters focused on measuring
the firm’s performance in the financial environment by understanding financial statements, calculating free cash flow, and analyzing ratios.
Time value of money and bond valuation. Chapter 4 covers the time value of
money and Chapter 5 applies these concepts to bond pricing. Thus, students learn a
tool and then immediately use the tool.
Dividends and stock repurchases before capital structure decisions. We now
cover dividends and stock repurchases in Chapter 14 so that students will already understand stock repurchases when we discuss recapitalizations in Chapter 15.
Notable Changes within Selected Chapters
We made too many small improvements within each chapter to mention them all,
but some of the more notable ones are discussed below.
Chapter 1: An Overview of Financial Management and the Financial
Environment. We added a new box on globalization, “Columbus Was Wrong—
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Preface
the World Is Flat! And Hot, and Crowded,” and a new box on the global economic
crisis, “Say Hello to the Global Economic Crisis!” We completely rewrote the section on financial securities, including a discussion of securitization, and added a new
section on the global crisis. New figures showing the national debt, trade balances,
federal budget deficits and the Case-Shiller real estate index help us better illustrate
different aspects of the global crisis.
Chapter 2: Financial Statements, Cash Flow, and Taxes. A new opening vignette shows the cash that several different companies generated and the different ways
that they used the cash flow. We added a new box on the global economic crisis that
explains the problems associates with off-balance-sheet assets, “Let’s Play Hideand-Seek!” We added a new figure illustrating the uses of free cash flow. We now have
two end-of-chapter spreadsheet problems, one focusing on the articulation between the
income statement and statement of cash flows, and one focusing on free cash flow.
Chapter 3: Analysis of Financial Statements. We added a new box on marking
to market, “The Price is Right! (Or Wrong!),” and a new box on international accounting standards, “The World Might be Flat, but Global Accounting is Bumpy!
The Case of IFRS versus FASB.” We have included discussion of the price/EBITDA
ratio, gross profit margin, and operating profit margin; we also explain how to use
the statement of cash flows in financial analysis.
Chapter 4: Time Value of Money. We added three new boxes: (1) “Hints on
Using Financial Calculators,” (2) “Variable Annuities: Good or Bad?”, and (3) “An
Accident Waiting to Happen: Option Reset Adjustable Rate Mortgages.”
Chapter 5: Bonds, Bond Valuation, and Interest Rates. We added four new
boxes related to the global economic crisis: (1) “Betting With or Against the U.S.
Government: The Case of Treasury Bond Credit Default Swaps,” (2) “Insuring
with Credit Default Swaps: Let the Buyer Beware!” (3) “Might the U.S. Treasury
Bond Be Downgraded?” and (4) “Are Investors Rational?” We also added a new table
summarizing corporate bond default rates and annual changes in ratings.
Chapter 6: Risk, Return, and the Capital Asset Pricing Model. The new opening vignette discusses the recent stock market and compares the market’s returns to GE’s
returns. We added a new box on the risk that remains even for long-term investors,
“What Does Risk Really Mean?” We added two additional boxes on risk, “How Risky
Is a Large Portfolio of Stocks?” and “Another Kind of Risk: The Bernie Madoff Story.”
Chapter 7: Stocks, Stock Valuation, and Stock Market Equilibrium. A new
opening vignette discusses buy- and sell-side analysts. We added a new box on behavioral issues, “Rational Behavior vs. Animal Spirits, Herding, and Anchoring
Bias.” We added a new section, “The Market Stock Price vs. Intrinsic Value.”
Chapter 8: Financial Options and Applications in Corporate Finance. We
completely rewrote the description of the binomial option pricing model. In addition
to the hedge portfolio, we also discuss replicating portfolios. We now provide the
binomial formula and we show the complete solution to the 2-period model. To provide greater continuity, the company used to illustrate the binomial example is now
the same company used to illustrate the Black-Scholes model. Our discussion of put
options now includes the Black-Scholes put formula.
Chapter 9: The Cost of Capital. We added a new figure to highlight the similarities and differences among capital structure weights based on book values, market
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xxiii
values, and target values. We added a new box, “GE and Warren Buffett: The Cost
of Preferred Stock.” We completely rewrote our discussion of the market risk premium, which now includes the impact of stock repurchases on estimating the market
risk premium. We also present data from surveys identifying the market risk premia
used by CFOs and professors.
Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows. We
added a new box, “Why NPV is Better than IRR.”
Chapter 11: Cash Flow Estimation and Risk Analysis. We now show how to
use tornado diagrams in sensitivity analysis. We rewrote our discussion of Monte
Carlo simulation and show how to conduct a simulation analysis without using addins but instead using only Excel’s built-in features (Data Tables and random number
generators). We have included an example of replacement analysis and an example of
a decision tree showing abandonment. We added a new box, “Are Bank Stress Tests
Stressful Enough?”
Chapter 12: Financial Planning and Forecasting Financial Statements. It is
difficult to do financial planning without using spreadsheet software, so we
completely rewrote the chapter and explicitly integrated the text and the Excel Tool
Kit model. We illustrate the ways that financial policies (i.e., dividend payout and
capital structure choices) affect financial projections, including ways to ensure that
balance sheets balance. The Excel Tool Kit model now shows a very simple way to
incorporate financing feedback effects.
Chapter 13: Corporate Valuation, Value-Based Management, and Corporate
Governance. The new opening vignette discusses the role of corporate governance in
the global economic crisis. We also added three new boxes. The first describes corporate governance issues at IBM, “Let’s Go to Miami! IBM’s 2009 Annual Meeting.”
The second discusses leadership at bailout recipients, “Would the U.S. Government
be an Effective Board Director?” The third discusses the 2009 proxy season, “Shareholder Reactions to the Crisis.”
Chapter 14: Distributions to Shareholders: Dividends and Repurchases. We
consolidated the coverage of stock repurchases that had been spread over two chapters and
located it here, which now precedes our discussion of capital structure in Chapter 15. We
also use the FCF valuation model to illustrate the different impacts of stock repurchases
versus dividend payments. We added two new boxes. The first discusses recent dividend
cuts, “Will Dividends Ever Be the Same?” and the second discusses Sun Microsystem’s
stock splits and recent reverse split, “Talk About a Split Personality!”
Chapter 15: Capital Structure Decisions. The new opening vignette discusses recent bankruptcies and Black & Decker efforts to reduce liquidity risk by refinancing
short-term debt with long-term debt. Because the stock repurchases are now covered
in the preceding chapter, we were able to improve our discussion of recapitalizations
within the context of the FCF valuation model. We added a new box, “Deleveraging”
that discusses the changes in leverage many companies and individuals are making in
light of the global economic crisis.
Chapter 16: Working Capital Management. We reorganized the chapter so
that we now discuss working capital holdings and financing before discussing
the cash conversion cycle. We rewrote our coverage of the cash conversion cycle to
explain the general concepts and then apply them to actual financial statement data.
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Preface
We added the box “Some Firms Operate with Negative Working Capital!” and a
new section on the cost of cost of bank loans.
Chapter 17: Multinational Financial Management. We added a new opening
vignette on the global economic crisis and its impact on world economies, foreign
direct investment, and cross-border M&As. We added two new boxes, the first on
regulating international bribery and taxation, “Greasing the Wheels of International
Business.” The second new box discusses the wave of foreign companies partnering
with Chinese banks to provide consumer finance services, “Consumer Finance in
China.”
Chapter 18: Lease Financing. The new opening vignette discusses Virgin Atlantic’s order of 10 Airbus jets to be leased from AerCap. A new box addresses the
FASB/IASB movement to capitalize all leases, “Off-Balance Sheet Financing: Is it
Going to Disappear?”
Chapter 19: Hybrid Financing: Preferred Stock, Warrants, and Convertibles.
The new opening vignette discusses the Treasury Department’s use of preferred stock
and warrants to support troubled companies. A new box discusses the use of paymentin-kind preferred stock in the merger of Dow Chemical Company and Rohm & Haas,
“The Romance Had No Chemistry, But It Had a Lot of Preferred Stock!”
Chapter 20: Initial Public Offerings, Investment Banking, and Financial
Restructuring. The new opening vignette discusses three companies that recently
raised capital via an initial public offering, a seasoned stock offering, and a debt offering. We added a new section on investment banking activities. We added a new box
on “Investment Banks and the Global Economic Crisis.”
Chapter 21: Mergers, LBOs, Divestitures, and Holding Companies. We
added a section explaining how the stock-swap ratio is determined for mergers where
the payment is in the form of the acquiring company’s stock.
Chapter 22: Bankruptcy, Reorganization, and Liquidation. The new opening
vignette discusses the bankruptcies of Lehman Brothers, Washington Mutual, Chrysler, and General Motors. We added a new box on personal and small business bankruptcies, “A Nation of Defaulters?”.
Chapter 23: Derivatives and Risk Management. The new opening vignette
discusses risk management at Koch Industries, Navistar, and Pepsi. We added a new
box on “Value at Risk and Enterprise Risk Management.” Throughout the chapter
we discuss the failure of risk management during the global economic crisis.
Chapter 24: Portfolio Theory, Asset Pricing Models, and Behavioral
Finance. We added a box on the WSJ contest between dart-throwers and investors,
“Skill or Luck?”. We expanded our discussion of the Fama-French 3-factor model and
included a table showing returns of portfolios formed by sorting on size and the bookto-market ratio.
Chapter 25: Real Options. The new opening vignette discusses Honda’s flexible
manufacturing plants.
Aplia Finance
Aplia Finance, an interactive learning system, engages students in course concepts,
ensures they practice on a regular basis, and helps them prepare to learn finance
through a series of tutorials. Created by an instructor to help students excel, book-
Preface
xxv
specific problem sets have instant grades and detailed feedback, ensuring students
have the opportunity to learn from and improve with every question.
Chapter assignments use the same language and tone of the course textbook, giving students a seamless experience in and out of the classroom. Problems are automatically graded and offer detailed explanations, helping stude